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Lecture Notes: Chapter 13: Stabilization Policy
J. Bradford DeLong
Economic Policy Institutions
Monetary policy in the United States is made by the Federal Reserve, which is our central bank. In other countries the central bank bears a different name. The most common is the name of its country: the central bank of country X is probably named "The Bank of X."
The principal policy-making body of the Federal Reserve system is its Federal Open Market Committee [FOMC]. It is the FOMC that lowers and raises interest rates, and that increases and decreases the money supply. The Federal Reserve's Board of Governors can alter bank regulations, and can and raise or lower the interest rate at which the Federal Reserve itself lends to banks and businesses. But most of the time it is the FOMC that plays the leading role within the Federal Reserve.
Today the Federal Reserve is the most important organization making macroeconomic policy. Because monetary policy is the most powerful tool for stabilizing the economy, the Federal Reserve plays the leading role in stabilization policy. Fiscal policy plays second fiddle. This institutional division of labor is probably the correct one. Over the past 50 years in the United States monetary policy has proven itself to be more powerful, faster-acting, and more reliable than fiscal policy.
The Federal Reserve
The Federal Reserve has a central office and twelve regional offices. Its central office is the Board of Governors, comprised of a Chair, a Vice Chair, and five Governors, all of them nominated by the President and confirmed by the Senate. The Board of Governors' offices are in Washington D.C.
The Federal Reserve’s twelve regional offices are the twelve Federal Reserve Banks. They are scattered around the country. There are Federal Reserve Banks in San Francisco, Minneapolis, Dallas, Kansas City, St. Louis, Chicago, Cleveland, Atlanta, Richmond, Philadelphia, New York, and Boston.
The members of the Board of Governors and the Presidents of the twelve regional Federal Reserve Banks meeting together make up the Federal Open Market Committee [ FOMC], which is the principal policy-making body. The Chair, the Vice Chair, the other five Governors, and the President of the Federal Reserve Bank of New York are always voting members of the FOMC. The eleven Presidents of the other Federal Reserve Banks alternate. At any moment four of them are voting members and seven of them are non- voting members of the FOMC.
The Federal Reserve was created just before World War I. Its Congressional architects feared that a unitary central bank based in Manhattan would pay too much attention to the interests of bankers and financiers and not enough attention to the interests of merchants and producers. A near-century of experience, however, suggests that they were wrong: bankers in St. Louis think like bankers in New York.
The Federal Reserve failed to handle its first great crisis, the Great Depression that started in 1929. Depending on who you believe, the Federal Reserve either did nothing to help cure the Great Depression, or it made things much worse and played a major role in causign the Great Depression. Since World War II, however, the Federal Reserve has done a much better job: there has been no repeat of the Great Depression.
The Federal Reserve's performance in the 1970s is generally regarded as inadequate. The 1970s were a decade of rising inflation and relatively high unemployment. Today, after two straight decades in the 1980s and 1990s of very successful monetary stabilization policy, the prestige of the Federal Reserve is high. It has almost unlimited freedom to conduct monetary policy as it wishes. Few outside the organization wish to challenge its judgments or decisions.
The FOMC tries to reach its decisions by consensus. If a consensus cannot be achieved, the members of the FOMC are more likely to postpone the issue than to make a decision that some substantial minority of its members oppose. However, once the FOMC decides on a change in policy that change is implemented immediately. It takes only minutes for
It is possible to envision situations in which this inability of the Federal Reserve to push nominal interest rates below zero has destructive consequences. If prices are expected to fall--if it is a time of anticipated deflation, so that the expected inflation rate is negative-- a nominal interest rate that is close to but not less than zero may still be a relatively high real interest rate, because the real interest rate r is the difference between the nominal interest rate i and the expected inflation rate πe. r = i - π e If the expected inflation rate is sufficiently far below zero, the real interest rate will be high, and investment low, no matter what the FOMC does.
Fiscal policy in the United States today is managed by the Congress (subject to the veto of the President). The Congress passes laws which the President then signs (or vetoes-- and the Congress then overrides or fails to override the vetoes). The Congress's tax laws determine the taxes imposed by the Federal Government. The Congress's spending bills determine the level of government purchases. Together these taxes and government purchases make up the government's fiscal policy.
The Budget Process
Departments plan
Congress considers and votes on spending bills
Congressional committees accept, amend, and reject Presidential budget proposals
Congress passes its budget resolution
President adds his priorities and submits a budget to the Congress
Departments negotiate with the President's Office of Management and Budget
Presidential resolutions?Continuing vetoes?
Government shutdowns?
Legend: The process by which the Congress and the President make fiscal policy is arcane and byzantine.
Some broad classes of expenditure, called "mandatory," are the result of open-ended long-term government commitments, and continue whether or not Congress explicitly appropriates money for them in the current year. Social Security, Medicare, Medicaid, unemployment insurance, food stamps, and so forth fall into this category of so-called "mandatory" spending. Other broad classes of expenditure, called "discretionary," must be explicitly appropriated by Congress in each fiscal year. Defense spending, the National Park Service, NASA, the National Institutes of Health, highway spending, education spending, and so forth fall into this category of so-called "discretionary" spending.
Federal Reserve more effective at undertaking stabilization policy to manage aggregate demand.
The History of Economic Policy
The government did not always see itself as being responsible for stabilizing the economy and taming the business cycle. It accepted this responsibility in the Employment Act of 1946, which:
- established Congress’s Joint Economic Committee.
- established the President's Council of Economic Advisers.
- called on the President to estimate and forecast the current and future level of economic activity in the U.S.
- announced that it was the "continuing policy and responsibility" of the federal government to "coordinate and utilize all its plans, functions, and resources... to foster and promote free competitive enterprise and the general welfare; conditions under which there will be afforded useful employment for those able, willing, and seeking to work; and to promote maximum employment, production, and purchasing power."
Passage of the Employment Act marked the rout of the belief that the government could not stabilize the economy and should not try to do so. In this view, monetary and fiscal policies to fight recessions would keep workers and firms producing in unsustainable lines of business and levels of capital intensity, and would make the depression less deep only at the price of making it longer.
This doctrine that in the long run even deep recessions like the Great Depression would turn out to have been "good medicine" for the economy drew anguished cries of dissent even before World War II. John Maynard Keynes tried to ridicule this "crime and punishment" view of business cycles, concluding that he did not see how "universal bankruptcy could do us any good or bring us any nearer to prosperity…" Indeed, it was largely due to Keynes's writings, especially his General Theory of Employment, Interest and Money , that economists and politicians became convinced that the government could halt depressions and smooth out the business cycle. But Keynes was not alone. For example, Ralph Hawtrey, an advisor to the British Treasury and the Bank of England, called it the equivalent of "crying, 'Fire! Fire!' in Noah's flood." But you still can see traces of this view in economics in places (like the real business cycle theories discussed at the end of chapter 7).
The high water mark of confidence that the government could and would manage to use its macroeconomic policy tools to stabilize the economy came in the 1960s. In that decade President Johnson’s chief economic advisor, Walter Heller, wrote of the New Dimensions of Political Economy that had been opened by the Keynesian Revolution. The Department of Congress changed the title of its Business Cycle Digest to the Business Conditions Digest --because, after all, the business cycle was dead.
The 1970s, however, erased that confidence. Economists Milton Friedman and Edward Phelps had warned that attempts to keep the economy at the upper left corner of the Phillips curve would inevitably cause an upward shift in inflation expectations--that even if expectations had truly been static during the 1950s and early 1960s, they would become adaptive if unemployment were pushed too low for too long. Friedman and Phelps were correct: the 1970s saw a sharp upward shift in the Phillips curve as people lost confidence in the commitment of the Federal Reserve to keep inflation low, and raised their expectations of inflation. The result was stagflation: a combination of relatively high unemployment and relatively high inflation. The lesson learned was that attempts to keep unemployment low and the level of output stable were counterproductive if they eroded public confidence in the central bank's commitment to keep inflation low and prices stable.
The 1970s ended with many economists convinced that "activist" monetary policy did more harm than good, and that the United States might be better off with an "automatic" monetary policy that fixed some control variable like the money stock to a stable long- run growth path. But the sharp instability of monetary velocity since the start of the 1980s has greatly reduced the number of advocates of such an "automatic" central bank, that lets the money stock grow by a fixed proportional amount in every year.
The Power and Limits of Stabilization Policy
Because economic policy works with long and variable lags, stabilization policy requires that we first know where the economy is and where it is going. If future conditions cannot be predicted, policies initiated today are as likely to have destructive as constructive effects when they affect the economy eighteen months or two years from now.
There are in general two approaches that economists take in trying to forecast the near- term future of the economy. The first approach is to use large-scale macroeconometric models--more complicated versions of the models of this book. The second approach is to search for leading indicators: one or a few economic variables not necessarily noted in this book that experience tells us are strongly correlated with future movements in real GDP or inflation. The U.S. government used to, and a private economjcs research group called the Conference Board now, publishes a monthly index of leading economic indicators--eleven factors averaged together that many economists believe provide a good guide to economic activity nine or so months in the future.
The leading indicator that has been most closely watched is the money supply. Before the instability of the 1980s monetarists used to claim that the appropriate measure of the money stock is the only leading indicator worth watching. If the central bank could guide the money stock to the appropriate level through open market operations, then success at managing the economy will immediately and automatically follow.
Different measures of the money stock say different things about monetary policy. Republican Party critics of Alan Greenspan continue to blame his tight money policies for George H.W. Bush’s defeat in the presidential election of 1992: during that year M grew by less than one percent. Supporters of Greenspan’s point to the extraordinarily- rapid growth of M1 (and short-term real interest rates of less than zero) as evidence of extraordinarily stimulative recession-fighting monetary policy. To say that the money stock is the single most important leading indicator is unhelpful if different measures of “the” money stock say different things.
Different Measures of the Money Stock Behave Differently
Annual Growth Rates of Money Stock Measures
-5%
-3%
-1%
1%
3%
5%
7%
9%
11%
13%
15%
1980 1985 1990 1995 2000
Year
M M M
Legend: Since 1980 the different measures of the money stock have ceased to move together. A year (like 1996) in which M1 falls can also see M3 grow, with a difference between the two of more than ten percentage points per year. Source: Economic Report of the President,
It is much harder to be a monetary economist than it used to be.
Even if economists have good reliable forecasts, changes in macroeconomic policy affect the economy with long lags and have variable effects. Estimates of the slope of the IS
collections and withholdings automatically rise because incomes rise. Spending on social welfare programs like food stamps falls because higher employment and higher wages mean that fewer people are poor. Thus the government budget moves toward surplus, without Congress passing or the President signing a single bill. And if the economy enters a recession, tax collections fall, social welfare spending rises, and the government’s budget swings into deficit.
As unemployment rises and national income falls, taxes fall by about 30 cents for every dollar fall in national product. Spending rises by about 7 cents for every dollar fall in national product. A $1 fall in national product produces only a fall of 70 cents in consumers' disposable income. Thus automatic stabilizers provide more than one dollar's worth of a boost to aggregate demand for every three dollar fall in production.
Such fiscal automatic stabilizers would be large enough to reduce the marginal propensity to spend from about 0.6 to about 0.4. This would imply a reduction in the size of the multiplier from about 2.5 to about 1.67. Business cycles could be considerably larger if these automatic stabilizers did not exist, if the Federal Reserve found itself unable to compensate for their disappearance, and if their disappearance did not lead to counteracting changes in the marginal propensity to spend.
Rules vs. Authorities In the late 1940s Chicago School economist Henry Simons set the terms for a debate over macroeconomic policy that continues to this day. He asked if macroeconomic policy be conducted "automatically," according to rules that would be followed no matter what? Or should macroeconomic policy be left to authorities--bodies of appointed officials-- provided with wide discretion over how to use their power and given general guidance as to what goals to pursue?
Competence and Objectives
The first reason for automatic rules is that we fear that the people appointed to authorities will be incompetent. If people are appointed because of friendships from the past, or because of their ability to rally campaign contributions for a particular cause, there is
little reason to think that they will be skilled judges of the situation or insightful analysts. Better then to constrain them by automatic rules. Even if those appointed to authorities are well-intentioned, they may well fail to find good solutions to macroeconomic problems. The stream of public discourse about macroeconomics is polluted by a large quantity of misinformation.
A second reason for fixed rules is that authorities might not have the right objectives. To institute a good rule it is only necessary for the political process to make the right decision once--at the moment the rule is settled. But an authority making decisions every day may be more likely to start pursuing objectives that conflict with the long-run public interest. The state of the economy at the moment of the election is a powerful influence on citizens' votes. Thus politicians in office have a personal power incentive to pursue policies that will sacrifice the health of the economy in the future in order to obtain good reported economic numbers during the election year.
The substitution of technocratic authorities--like the Federal Reserve--in the place of Presidents, Prime Ministers, and Finance Ministers provides some insulation. It is this fear that politicians will have objectives different from the long-run public interest that has led many to advocate that monetary policy be made by independent central banks. If stabilization policy is to be made by authorities, it should be made by authorities placed at least one remove from partisan politics.
Economic Policy: The Political Business Cycle and Richard Nixon
The most famous example of the political business cycle at work comes from American politician Richard Nixon's episodic autobiography, Six Crises, that he published in 1962. Looking back on his defeat in the 1960 Presidential election by John F. Kennedy, Nixon wrote that:
"Two other developments [that] occurred before the [Republican Party C]onvention… [had] far more effect on the election outcome...
"Early in March [1960], Dr. Arthur Burns... called on me.... [He] expressed great concern about the way the economy was then acting.... Burns’ conclusion was that unless some decisive government action were taken, and taken soon, we were heading for another economic dip which would hit its low point in October, just
The verdict is that Richard Nixon dearly wished for the Federal Reserve to tune economic policies in a way that would enhance his reelection chances, but that the institutional independence of the Federal Reserve worked. White House political pressure in 1971-1972 led to little if any change in Federal Reserve policy.
Details: Is There in Fact a Political Business Cycle?
Few would dispute that politicians seek to tune the macroeconomy to their political advantage. The Bush administration tried to persuade Federal Reserve Chair Alan Greenspan to pursue a more expansionary monetary policy in 1991 to produce better economic numbers for the George Bush reelection campaign in 1992, going as far as threatening not to nominate Greenspan for a second term as Federal Reserve Chair. But it was unsuccessful. Richard Nixon certainly believed when he appointed Arthur Burns to be Fed Chair that Burns would still be the loyal partisan supporter he had been in 1960--contemplating this appointment Nixon referred to the "myth of the autonomous Fed" and laughed.
But how successful are governments at manipulating the political business cycle? It is not clear. It is true that in the United States since 1948 the fourth year of a President's term--the Presidential election year--has seen annual real GDP growth average 0.6% more than the average of non-Presidential election years. But there is a fifteen percent probability that at least that large a difference would emerge from random chance and sampling variation alone. Faster growth in Presidential election years is suggestive, but not conclusive.
Moreover, other ways of looking at the data deliver even less evidence. Out of twelve post-1948 Presidential terms, fully six--Johnson, Nixon-Ford, Carter, Reagan II, Bush, and Clinton I--saw slower economic growth in the politically- relevant second half of the term than in the first half of the term. This alternative way of looking at the data provides not even a suggestion of evidence one way or another. And it is important when analyzing any situation not to choose to look only at the data in the way that makes one's preferred conclusion appear the strongest.
There is, however, stronger evidence not of a politically-motivated component to the business cycle but of a politics-influenced component to the business cycle. In
all seven post-WWII Presidential terms in which Republicans have occupied the White House, growth in the second year of a Presidential term has been lower than average real GDP growth over that term. By contrast, in only one of the six terms in which Democrats have occupied the White House has second-year growth been lower than average.
The odds against this pattern happening are astronomical: there is less than one chance in a thousand that it could be the result of random sampling variation.
Economist Alberto Alesina interprets this pattern as showing that the political parties have--or had, for Clinton is the Democratic President for whom the pattern of growth fits the Republican model--different views of the relative costs of unemployment and inflation. Republicans have more tolerance for unemployment and less tolerance for inflation than Democrats do. Hence when Republicans come into office the Federal Reserve feels more free to try to push inflation down to a lower level. Because a considerable portion of inflation expectations relevant for the second year of a Presidential term were formed back before the result of the election is known, actual inflation in the second year of a term is less than expected inflation and so economic growth is relatively low.
Alberto Alesina and Lawrence Summers concluded that the more independent a central bank, the better its inflation performance. More independent central banks presided over lower average inflation and less variable inflation. Moreover, countries with independent central banks did not pay any penalty. Countries with independent central banks did not have higher unemployment, lower real GDP growth, or larger business cycles.
Interpreting this correlation is not straightforward. Perhaps the factors that lead countries to have independent central banks lead them to have low inflation. Perhaps independent central banks do reduce economic growth, but only countries likely to have high economic growth for other reasons are likely to have independent central banks. Nevertheless, at least the post-1950 experience of the industrialized countries strongly suggests that central bank insulation from partisan politics delivers low inflation without any visible macroeconomic cost.
Central Bank Insulation from Politics and Inflation
Legend: Countries whose central banks are more independent have lower average inflation rates. Source: Alberto Alesina and Lawrence Summers (1993), "Central Bank
Independence and Macroeconomic Performance ", Journal of Money, Credit and Banking.
Credibility and Commitment
There is always a temptation for the central bank to pursue a more expansionary monetary policy: More expansionary policy raises national product and reduces the unemployment rate. Moreover, it has little impact on inflation in the short run in which expectations of inflation are more-or-less fixed. In the short run, expansionary monetary policy does always seem to be a central bank's best option. Suppose firms and unions agree on large nominal wage and price increases. Then in the short-run it is best for the central bank to accomodate inflation and expand the money supply. To fight inflation by raising interest rates would generate a recession, and inflation would continue anyway. Suppose instead that firms and unions decide on wage and price restraint. Expansionary monetary policy is still better--inflation will be low, and the economy will boom.
In either case, pursuing a more expansionary monetary policy produces a better short-run outcome. Moreover, announcing that monetary policy will be more restrictive produces a better short-run outcome as well, for by announcing that fighting inflation is job one the central bank may influence the expectations of workers, managers, investors, and households.
So why--given the obvious short-run benefits of a more expansionary monetary policy-- should anyone ever believe that a central bank will aim for low inflation?
Yet in the long run, it is surely the case that a central bank is wiser to keep low inflation as its top priority. Central banks benefit if workers, firms, and investors all believe that future inflation will be low. A central bank that succumbs to the temptation to make inflation higher than expected loses its credibility. All will soon recognize that the central bank's talk is cheap, and that it has a strong incentive once expectations relevant to a period of time are formed to make inflation and money growth higher than expected. So the central bank will find that its words about future policy are ignored in the process of setting expectations. And expectations of inflation will be sky-high.
