Limitations of Stabilization Policies

It is tempting to conclude that economists and informed policy makers have their thumb on the pulse of the economy and that they can diagnose and cure any economic malady that might occur. But even with advancements in economic modeling and forecasting, and the many lessons learned from earlier bouts with similar economic problems, economic science lacks the precision of the physical sciences. After all, economic science deals with the behaviors of people, which are often unpredictable. As a result, there are certain limitations to society's ability to achieve macroeconomic goals such as economic growth and stability through monetary or fiscal policies.

One limitation of monetary and fiscal policies concerns the timeliness of the government's response to changing economic conditions. Time lags occur between the recognition of an economic problem, and the creation and implementation of appropriate stabilization policies to deal with the problem. For example, it was not until December 2008 that the National Bureau of Economic Research (NBER) announced that the U.S. economy had entered into a recession in December 2007. Thus, the NBER announcement came a year after the change in the business cycle had occurred. Time lags are inevitable considering the complexity of modern economies. Time lags are especially troublesome when formulating fiscal policy because a greater number of elected representatives in Congress must agree on a suitable set of tax policies and spending programs.

A second limitation is the politicization of economic problems. Political pressure on elected officials has risen dramatically in recent years. The architects of fiscal policy in Congress feel these pressures. Political gridlock has thwarted the spirit of compromise on sensitive issues related to taxation and government spending—the two main tools of fiscal policy. From 2009 to 2012 this gridlock even prevented the federal government from passing a federal budget. Political gridlock associated mainly with the funding of the Affordable Care Act also resulted in a partial federal government shutdown in October 2013. Appointed governors of the Federal Reserve System, on the other hand, are more sheltered from political pressures as they form the nation's monetary policy.

A third limitation is the uncertainty of policy coordination. There is sometimes disagreement between the Fed and the nation's highest elected officials about what constitutes an appropriate stabilization policy. In the early 1980s, for example, the United States faced two economic problems: rising inflation and recession. Fed chairman Paul Volcker implemented a tight money policy, which decreased aggregate demand, to fight skyrocketing inflation. Meanwhile, President Ronald Reagan and Congress pursued aggressive tax cuts—an expansionary fiscal policy—to reverse the economic downturn and revive the sputtering economy. These conflicting policies sent mixed messages to the economy.

Different Approaches to Stabilization

The classical school of economic thought opposed most government intervention in the economy. In his book An Inquiry into the Nature and Causes of the Wealth of Nations (1776), British economist Adam Smith created the intellectual foundations for the classical school. In the United States, classical school economists supported laissez-faire capitalism during the 1800s and early 1900s. Laissez-faire capitalism relied on free and competitive markets to allocate resources in a fair and efficient manner. Government intervention, on the other hand, was viewed as an obstacle to economic progress. The government's main function was to provide for the nation's security against foreign and domestic threats and provide a sound business environment, not to regulate businesses, provide a social safety net, or tinker with business cycles. The severity of the Great Depression of the 1930s caused many people to reject the classical school's laissez-faire views and, instead, turn toward additional government involvement in the economy.

The Keynesian school of thought championed demand-management economics. In The General Theory of Employment, Interest, and Money (1936), John Maynard Keynes rejected classical economics and supported a more activist role for government to promote growth and stability. Soon the followers of Keynes were referred to as Keynesians. Keynesians supported aggressive monetary and fiscal policies to influence aggregate demand in the economy—to increase aggregate demand during times of recession and reduce aggregate demand during times of inflation. During the Great Depression of the 1930s, the most serious economic downturn of the twentieth century, the Keynesians urged the Fed to adopt an easy money policy and urged Congress and the president to adopt an expansionary fiscal policy. Keynesians influenced government stabilization policies for decades after the Great Depression ended. The introduction of a new type of instability— stagflation—during the 1970s, rained on the Keynesians' parade, however. Stagflation is the simultaneous occurrence of recession and high inflation. The Keynesian approach to stabilization was ill equipped to fight recession and inflation at the same time. Despite this

Many people supported a larger role for government in the U.S. economy during the Great Depression

Many people supported a larger role for government in the U.S. economy during the Great Depression (1930s). (Library of Congress)

setback, some economists and policy makers still hold fast to Keynesian ideas, as evidenced by the easy money policies and expansionary fiscal policies used to address the Great Recession of 2007–2009.

Monetarism, another approach to stabilization, gained momentum during the 1970s.

Monetarism favored a fixed, predictable rate of growth in the nation's money supply as the surest road to long-term prosperity. Monetarists, led by economist Milton Friedman, also believed that free markets and a resilient private sector should guide economic activity. Monetarists cheered when Fed chairman Paul Volcker instituted strict guidelines on the growth of the nation's money supply to quell spiraling inflation during the late 1970s. This policy reigned in inflation but also contributed to a severe recession by the early 1980s.

Supply-side economics, a stabilization approach that gained popularity during the presidency of Ronald Reagan in the 1980s, stressed the role of incentives to stimulate productivity and economic growth. Supply siders stressed the role of incentives to instigate higher productivity and national output. The supply-side approach to stabilization relied on policies to increase aggregate supply, rather than to manipulate aggregate demand in the economy. Aggregate supply represents the total output of goods and services in an economy. President Ronald Reagan (1981–1989) staunchly supported the supply-side approach to stabilization during his presidency. Reagan believed that proper supply-side incentives must include tax cuts as well as reductions in business regulations and wasteful government spending. The centerpiece of Reagan's supply-side agenda was the Economic Recovery Act of 1981, which cut personal and corporate income taxes by 25 percent between 1982 and 1984. Economist Arthur Laffer, through the Laffer curve, explained that lower tax rates would generate greater tax revenues by expanding the tax base. Economists still debate the impact of supply-side policies on the prolonged expansion of the 1980s and on the massive federal deficits of the period.

In recent years new classical economics has become an influential school of thought in the stabilization debate. New classical economics assumes that both wages and prices are flexible and that people have sufficient economic information to anticipate government economic policies. Much of what is “new” in the new classical economics centers on the rational expectations hypothesis, a theory developed by Nobel Laureate Robert E. Lucas Jr. and other economists at the University of Chicago. According to the rational expectations hypothesis, people are privy to an immense body of economic information and by using “all available information” they will, on average, accurately predict future economic events, including monetary policy and fiscal policy. People's expectations, in turn, influence their present economic behaviors such as saving, investing, and spending, which limit the effectiveness of future stabilization policies. Critics of the rational expectations hypothesis argue that people have neither the time nor the inclination to collect and analyze the economic data needed to anticipate government policies or predict future economic outcomes.

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