Fighting Business Cycles With STABILIZATION POLICIES
As you may recall, the twins, Donna the Democrat and Rhonda the Republican, seldom agree on anything involving politics, economics, fashion, or flower arrangements. Their imminent entry into the Interstate OmniBank can only mean trouble. Donna, in her official capacity as economic advisor to the President of the quaint and courteous Republic of Northwest Queoldiola, is attempting to enter Interstate OmniBank anxious to borrow enough to finance the Queoldiolan government deficit. Rhonda, as the head of the central bank of the Republic of Northwest Queoldiola, is making every effort to stop her. The source of this particular confrontation between the twins is apparently the best way to eliminate a year-long recession that has struck the quaint and courteous Republic of Northwest Queoldiola.
Smoothing the Economy
Consistent with her political and philosophical beliefs, Donna is confident that the best way to eliminate the Northwest Queoldiolan recession is for direct government involvement. Rhonda, in contrast, thinks that the government should let the economy work its way through recession on its own. In fact, Rhonda thinks that Donna and the President of Northwest Queoldiola caused the recession by monkeying around with the economy last year.
While Donna and Rhonda disagree on just about everything, they have in mind the same goal for the economy -- maintaining relatively smooth, long-run growth. Donna argues that this smoothing is best done by an active government role in the economy and Rhonda says the economy will remain smooth if the meddling government will just stop meddling.
The quaint and courteous Republic of Northwest Queoldiola is not the only nation facing this controversy. Right here in the good old U. S. of A., our government leaders of the first estate, together with their hired economist gunslingers, constantly debate this very issue. Considering the assorted problems of recessions and inflation that emerge from an unstable economy, let's ponder our government's policies that are intended to stabilize the economy.
Tools of the Trade
The government of every nation, whether the good old U. S. of A. or the quaint and courteous Republic of Northwest Queoldiola, has two basic ways of influencing the ups and downs of the economy.
- Fiscal budget. This stems from all of the taxing and spending that government does. Government can dramatically change the course of the economy by taxing more and spending less or spending more and taxing less. The key part of the fiscal budget is the federal deficit. In the good old U. S. of A., the fiscal budget is under the control of the President and Congress. In Northwest Queoldiola, this is Donna's domain.
- Money. While money may be the "root of all evil," it also has a big impact on the economy by making it easier or harder for everyone to produce and buy a slice of our economic pie. In the good old U. S. of A. the amount of money circulating about, making it possible to buy stuff, is under the direct control of the Federal Reserve System. In Northwest Queoldiola, this is Rhonda's realm.
Governments can also influence the shape, size, and growth of the economic pie through assorted laws, rules, and regulations. Our current interests, however, lie with the two we've already noted that go by the more formal names of fiscal policy and monetary policy.
Fiscal Policy with Congress and the Prez
Every year the President prepares; and Congress debates, changes, and eventually passes; the federal government's fiscal budget. For the most part this budget is aimed at raising and spending the tax dollars on the assorted stuff that our evil necessity of the first estate is responsible for doing -- national defense, education, transportation, legal system, etc.
The federal government agencies that beg for funds and most individual members of Congress who are willing to accommodate them, seldom consider the overall impact of the fiscal budget on the economy. That tends to be the job of handful of powerful government leaders. Of course, the President and the Speaker of the House of Representatives focus on the big picture painted by the budget. However, other pretty powerful first estate leaders, who seldom get much publicity, are the Chairman of the Council of Economic Advisors and the Director the Office of Management and Budget. These, along with the Chairman of the Congressional Appropriations Committee tend to be among the more important players in the game of fiscal policy. Keep an eye out for them on the news. They can make your life miserable if they want.
These first estate leaders deal with the overall level of government spending relative to taxes -- that is the federal deficit. A rise in the federal deficit tends to stimulate the national economy because the government is spending more dollars than it's taking away from consumers through taxes. A drop in the deficit tenda to contract the size of our economic pie, an appropriate move if we're besieged by high rates of inflation.
In principle, it matters very little if the deficit changes through spending or taxes. In practice, at least in recent decades, the government has tended to favor changes in taxes. It seems to be a little bit easier to change tax rates than it is to fool around with the various spending categories in the budget.
Monetary Policy and the Fed
Monetary policy is the result of the federal government's control over the nation's currency. That responsibility in the good old U. S. of A. falls under the jurisdiction of the Federal Reserve System. The Fed (as those who pretend they know a lot refer to the Federal Reserve System) is not only in charge of the money supply, they also oversee the entire banking system. While they've used this awesome power for a lot of different reasons over the years, one of the primary functions has been to make sure that our economy has enough money to function without triggering excessive inflation or letting the economy slip into a recession.
The Chairman of the Federal Reserve System -- the guy who's in charge of the whole show -- is also considered by many to be the second most powerful person in the country. During some Presidential administrations, he might be number one. The Chairman, who is assisted by a Board of Governors, assorted advisors, and plenty of staff economists, decides how much the money supply should grow each year to avoid inflation and recessions -- and to keep the economy smooth. Controlling the money supply is accomplished in two basic ways:
- Open market operations. This is the one most favored by the Chairman and his monetary cohorts. In involves the buying and selling of the government securities that make up the federal government's debt. These securities are traded regularly through financial markets. The Fed, however, has realized that when it buys securities it adds money to the economy and when it sells it takes money out. Rather than printing money, this is the Fed's method of changing the number of dollars in the economy.
- Discount rate. One thing the Fed does is make loans to troubled banks. The interest rate it charges on loans to those banks is the discount rate. A high discount rate discourages borrowing while a low discount rate encourages it. The borrowing, or lack thereof, is another way that the Fed has of pumping money into the economy. While this discount rate often gets of a lot of publicity, it's not all that effective in actually changing the money supply. The Fed primarily uses the discount rate as a signal to any interested party that it's also using open market operations -- the real workhorse of monetary policy.
Do These Policies Work?
The big question to ask now is which sort of stabilization policy (if any) should we recommend to our battling twins Donna and Rhonda? Donna wants to stimulate the economy with a deficit. Would some sort of monetary policy be better? Or perhaps Rhonda, who wants to let the economy grow out of the recession without any government action, should get her way.
Let's consider the consequences of stabilization policies.
- Dividing the economic pie. One difference between fiscal and monetary policy is who has the biggest slices afterwards. To stimulate the economy, fiscal policy reduces taxes or increases government spending. This tends to give consumers or government a larger share of the pie. It also tends to reduce the share for business investment. When monetary policy stimulates the economy, interest rates go down and business investment goes up. I think we can see a pattern here, stimulatory monetary policy favors the second estate while the first and third benefit from fiscal policy, depending on whether spending or taxes are used. However, everything is reversed for fighting inflation by contracting the economy.
- Economic growth. Based on differences in dividing the economic pie you might think that there's a corresponding difference in economic growth. For the most part there is. Any time you encourage business investment in capital, you're likely to see expanded growth. However, keep in mind that consumers and government also buy growth promoting capital goods, including but not limited to transportation infrastructure, education, and scientific research.
- Politics. As a general rule, most of us want lower taxes and more government services -- which helps to explain the size of our federal deficit. As such, stimulating the economy with fiscal policy is more politically palatable than using it to eliminate inflation. Since monetary policy affects voters indirectly, it tends to fall between these two fiscal policy extremes.
- Time lags. Monetary policy is a great deal quicker to do than fiscal policy. Fiscal policy, using the federal budget, needs agreement from Congress and the President. This takes time. Monetary policy, in contrast, needs only the decision of the Chairman of the Fed and a handful of the Board of Governors. Decisions are quick, and unlike fiscal policy, implementation also occurs with little delay. Fiscal policy only works after its gone through the entire government administrative bureaucracy -- a process that takes months or maybe even years.