Lesson 66: The Politics of Economic Decision Making
In this lesson, we will learn about the natural ups and downs in
the economy through the business cycle, focusing specifically on recessions and
the accompanying unemployment and inflation. We will then look at government
policies designed to try to control the economy, including fiscal policy and
monetary policy. We will also see how fiscal policy affects the public debt.
Ups and downs in the economy are to be expected and
when a recession hits, the government tries to be proactive.
A recession is an economic downturn,
usually characterized by a fall in the GDP and rising unemployment.
Unemployment is the inability of those who are in the labor force to find a job.
Another characteristic of recession is inflation,
or a sustained rise in the general price level of goods and services.
Studies show that
unemployment not only traumatically affects a person, but the whole economy.
That is why it is a goal of the government to combat high unemployment rates
and put programs in place like unemployment insurance, which is provided to
hardworking Americans who find themselves out of a job by no fault of their own.
Doing an accurate count to measure unemployment is difficult and it changes
every year, but it has steadily fallen since 2009 by the Bureau of Labor
Statistics. One complication of measuring unemployment is determining who is
actually considered unemployed – people who have dropped out of the workforce
and have given up on looking for a job are not counted as unemployed. This
percentage of the population that makes up the "hidden unemployed" dramatically
increased during the Obama years, with the workforce participation rate
dropping to a 38-year low of 62 percent in 2015.
There are
two ways of looking at inflation. One is that it reflects the rising costs of
products and services. The other is that it is actually a decline in the
purchasing power of the dollar. Inflation is measured using the CPI, or
Consumer Price Index, which is calculated by placing items purchased by a
typical consumer in a market basket of consumer goods and services. The Bureau
of Labor Statistics then rechecks the cost of that market basket over a period
of time.
Today's dollar has roughly the purchasing power of a nickel in 1916,
when you could buy a loaf of bread for a quarter.
Economists look at the ups and downs of economy as the business cycle.
Recessions are often mild and have happened regularly over the past 30 years,
but in the 1930s, there was an unusually severe recession called the Great
Depression. Since the Great Depression, the government has used several policy
options to try to control the ups and downs of the economy.
One approach the government uses to manage the economy is Fiscal Policy. That
is the federal government's use of taxation and spending policies to affect
overall business activity.
John Maynard Keynes was a 20th century economist who proposed active federal
government policymaking to stabilize economy-wide fluctuations, including the
use of discretionary fiscal policy. He believed that when the economy went
through a downturn, the government should stimulate spending by increasing its
own spending or cutting taxes to encourage taxpayers to spend more on goods and
services.
The idea was the following:
when people are
unemployed, they have nothing to spend. When people have nothing to spend,
businesses fail, creating a vicious cycle resulting in more unemployment.
Keynes' principle was that
government spending would put money into the cycle where it is needed. But,
there was a particular way it had to be done -- the government had to spend
more than it received, creating a budget deficit.
Keynes policy was meant to be used in
major disasters like the Great Depression, but under President Kennedy,
policymakers began to use the method to "fine-tune" the economy through what is
known as discretionary fiscal policy.
The problem with any solution is the timing. First,
it takes time for the problem to be identified. It can then take years to get
Congress to act. The implementation of the solution they come up with can take
years before the changes are visible. Years have gone by and the recession
could very well have righted itself before the effects of the solution are seen.
It is easier and
more efficient to grant tax cuts to boost the economy than it is for government
spending to spark it.
Of course,
not everyone is on board with the Keynesian school of thought. Opponents say
that fiscal policy has negative side effects that cause more damage than any
benefits are worth. Other opponents simply say it is best that the government
do nothing and let recessions work themselves out.
The system the government uses to borrow money is through U.S. Treasury bills,
simply called Treasuries.
Treasuries are actually U.S. Treasury securities— bills, notes, and bonds;
debt issued by the federal government.
The government sells these Treasuries to
corporations, private individuals, pension plans, foreign governments, and
foreign individuals. That is what gives us our public debt, or national debt.
The *net* public debt is really what is important because our *gross* public
debt includes what our own government agencies borrow from each other. The net
public debt is everything NOT including interagency borrowing.
Sticking with fiscal policy, the government consistently spent more than it
received each year from 1960 to 1998. The ongoing budget deficits were blamed
on negative effects of fiscal policy while other observers said the deficits
were due to an abuse of the policy. The fact is, there is another side to the
policy that Keynes proposed.
According to Keynes, during boom times, the government is supposed to
run a budget surplus, receiving more than it spends. Or at the very least, it
should keep the growth of debt below the growth of GDP.
There are
problems we could face if deficit spending continues. Even though it is
possible to continue selling treasuries and spending more than we have, many
economists fear that prolonged deficit spending could cause the world to lose
faith in our government, which could lead to higher interest rates and, in a
vicious cycle, lead to larger deficits.
Fiscal policy is not the only tool the government has at its disposal to try to
control the economy. Monetary Policy is another and involves the use of changes
in the amount of money in circulation to alter credit markets, employment, and
the rate of inflation.
The Federal Reserve System (the Fed) is the system created by Congress in 1913
to serve as the nation's central banking organization, and one of its most
important tasks is to monitor the amount of money in circulation.
Appointed by the president and approved by the Senate,
the board of governors consists of 7 full-time members. They preside over 12
district banks and the most important body called the Federal Open Market
Committee. The Federal Open Market Committee decides how monetary policy should
be carried out.
One important note is that
the Fed is completely independent. Although the members of the Federal Reserve
Board are appointed by the president and approved by the Senate, they do not
have power over the Fed. It is inaccurate when someone refers to certain
monetary policy as being of the president or Congress.
The Fed's goal is to stabilize the economy and it does that by controlling the
amount of money in circulation. It has tools that it can use. Credit and the
interest rate can be used to encourage economic growth as well as inflation.
There are
two main approaches to monetary policy. A loose monetary policy means
increasing the supply of credit and dropping the cost of borrowing. That
encourages economic growth when a business can afford to borrow more money for
more projects. The Fed uses tight monetary policy to decrease the supply of
credit and raise the cost of borrowing. The goal of tight monetary policy is to
control inflation.
The same time lag exists for monetary policy as it does for fiscal policy.
Nothing the government ever does has an immediate effect, but the effects of
monetary policy are usually seen sooner.
Also,
the Federal Open Market Committee can put monetary policy together more quickly
than the government can change its spending and borrowing habits.
The fact is that
monetary policy can be effective during most recessions. If the Fed uses loose
monetary policy, it can greatly increase economic activity which is exactly
what a recession needs… That is, if people are actually borrowing and banks
are actually lending.
During the Great Recession, the Fed dropped the interest to zero, yet
businesses still were not borrowing. People were reluctant to use the credit.
Economists compared it to "pushing a string" -- even though you can control the
supply of credit and the interest rate, you cannot grab people by the hand and
force them to take the money.
That is why the Obama administration went with fiscal policy to try to turn the
economy around. President Obama obtained legislation from Congress that pushed
the public debt to levels not seen since World War II, especially through his
$800 billion economic stimulus package. Little effect was seen with
unemployment rates remaining high. Keynesian economists argued that the
stimulus was less than half of what was needed to accomplish such a goal.