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Is Fiscal Policy Dead?

If you learn economics from some textbooks currently on the market, you might leave the course believing that discretionary fiscal policy remains the primary macroeconomic policy. However, for 20 years before President George W. Bush revived it, fiscal policy had largely disappeared from discussion of macroeconomic policy and it was rarely mentioned in the news. If it was not dead, it had become largely irrelevant. There were at least four reasons for this irrelevancy.

First, because discretionary fiscal policy changes tax laws or expenditure programs, it is entangled in the political process. In the United States, a change in tax rates or government spending must pass through the congressional committee structure and both houses of congress before the president signs it into law. If good politics were automatically good economics, this entanglement would not be a problem. However, many economists believe that good economic policy sometimes differs from good politics. There is a whole branch of economics called public choice theory that argues that the political process tends to favor policies with short-term benefits but long-term costs, or with visible benefits and hidden costs. The Bush revival of fiscal policy seemed largely due to political reasons, a desire by politicians to "do something" when there is a problem.

The story of the wage and price controls that the Nixon administration enacted in August, 1971 illustrates how good politics can differ from good economics. Both Nixon and his economic advisors thought wage/price controls were a terrible way to deal with inflation, which had gradually grown during the 1960s to emerge as a problem. Nixon's economic advisors believed that wage/price controls attack only symptoms of inflation rather than its root cause, which was excessive spending caused by past fiscal and monetary policies. Further, they understood and believed the standard microeconomic analysis that prices and wages provide essential information and incentives to determine what goods get produced. Distorting this information and these incentives leads to distortions in how resources are used that are usually undesirable.

Given this deep opposition to wage/price controls, why did the Nixon Administration impose them? Herbert Stein, chairman of the Council of Economic Advisors from 1972 to 1974, argues that political realities were key. The original game plan of the Nixon administration was to gently tighten monetary and fiscal policy, which they thought would bring down inflation without a big increase in unemployment. Looking back, Stein says that this game plan was unrealistic, but it left the public with expectations that could not be realized. Wage/price controls were suggested as an alternative way of bringing down inflation, and other than some economists, there was almost no one who opposed them. Most people expected controls would stop the prices they paid from rising, and few seemed to realize that they might also stop the prices they charged from rising.

In August of 1970, Congress passed a law giving the president the authority to impose wage/price controls, but did not endorse controls. This action was a win/win strategy for the Democrats who controlled Congress. If Nixon did not impose controls, they could continue to attack him for not acting strongly and decisively on inflation. If he did impose controls, they could wash their hands of responsibility of any problems of those controls since the program was the responsibility of the executive branch. When Nixon finally imposed controls, he explained to his advisors "that as much as he disliked imposing the controls, if he didn't do it the Democrats would win the presidency and they would impose permanent controls."1

Are there situations in which political incentives might threaten the integrity of fiscal policy? There may be. People like additional government spending and lower taxes, so political resistance to expansionary fiscal policy should be low. However, when the time comes to tighten fiscal policy, politicians will find that increasing taxes or reducing spending are unpopular. Given this asymmetry of incentives, fiscal policy should have a bias toward ease, resulting in larger government deficits than would otherwise exist. In addition, economists have worried that macroeconomic policy could be abused in the election cycle. Politicians could manipulate policy to get short-run and temporary benefits at election time at the cost of problems that occur in the longer run. Although the incentives exist for such manipulation, there is no convincing evidence that a political business cycle exists in the United States. Cynics believe its nonexistence is due to the limited effectiveness of existing policy tools.

The Federal Reserve does not experience political pressures with the same intensity that Congress and the President do. The fourteen-year terms that the Governors of the System serve were designed to insulate them from these pressures. In the past, when fiscal policy was still vital as an issue, there were some economists who envisioned a committee of experts similar to the Federal Reserve who could fine-tune the macroeconomy by changing taxes and spending. But this was an unrealistic vision because it ignored a second problem for fiscal policy, which is that tax and spending policy have many effects besides their macroeconomic effects.

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1Stein, Herbert. Presidential Economics: The Making of Economic Policy from Roosevelt to Reagan and Beyond. New York: Simon & Schuster. 1984, p. 182. 

Copyright Robert Schenk