Chapter 18: Economic Policy

Objectives:

1. Summarize how politics and public opinion shape economic policy.

   1. The politics of taxing and spending are so difficult mainly because most people don't like being taxed but do value government spending on a wide variety of government programs. Most voters want lower taxes, less debt, and new programs, but if we have more spending, we have to pay for it, either with higher taxes or with more borrowing (and hence more, not less, debt).

2. Summarize four main theories of economic policymaking.

   1. The four main theories of economic policy are 1) monetarism (inflation occurs when too much money chases too few goods), 2) Keynesianism (the government should spend more money when there is a recession and less when the economy is doing well), 3) economic planning (the government should actively plan the economy), and 4) supply-side economics (lower taxes will stimulate economic growth). Unfortunately, there is no consensus among economists about which one is best.

3. Describe how American institutions work to set economic policy.

   1. The difficulty is that many different actors play a role: the president, Congress, the Federal Reserve System, the Council of Economic Advisors, the Secretary of the Treasury, and hundreds of other agencies all contribute to economic policy. All of these actors have very imperfect control of the economy.

4. Explain the budget process, and in particular state why it is difficult to either cut spending or increase taxes.

   1. Restraining spending or raising taxes are difficult for several reasons. 1) Most government spending is mandatory spending required by law. 2) The general public and members of Congress like government spending and dislike taxes. Given this, restraining the growth of government is quite complicated.

Reasons For Government Debt:

• Deficit: Spending more than one earns
  • Financed by selling government bonds to Americans and foreigners
  • National debt: Total amount of all deficits
• Economic reason for debt
  • Bonds are always repaid.
  • People want to buy U.S. bonds because the dollar is stable and valuable.
  • Interest payments must be made each year.
  • Making interest payments may be more difficult as Social Security and Medicare costs increase with an aging population.
• Substantive argument about debt
  • Families borrow to buy long-lasting items, such as a home, car, or college education.
  • Government borrows money when it needs it without thought for long-term benefit.
• Political opposition to debt
  • Public is opposed to public debt, so politicians are, too.
  • Offer contrasting ways to combat it
  • Conservatives: Cut spending
  • Liberals: Raise taxes
  • People do not want cuts in spending, but they also do not want higher taxes; political stalemate usually results.

The Politics of Economic Prosperity

• Disputes about economic well-being tend to produce majoritarian politics.
  • Voters see connections between nation as a whole and their own situations.
  • Low-income voters more likely to worry about employment and vote Democratic.
  • High-income voters more likely to worry about inflation and vote Republican.
  • Voters respond more to condition of the national economy than of their own personal finances.
  • People understand what government can and cannot be held accountable for.
  • People see economic conditions having indirect effects on them even when they are doing well.
• What politicians try to do:
  • Government officials will sometimes use money to affect elections.
  • Patronage, veteran’s benefits, social security increases
  • Government will not always do whatever is economically necessary to win an election.
  • Government does not know how to produce all desirable outcomes.
  • Economic pressures are often interrelated.
  • Ideology plays large role in shaping policy choices.
  • Democrats focus on reducing unemployment.
  • Republicans focus on reducing inflation.

The Politics of Taxing and Spending

• Majoritarian politics is inconsistent.
  • Everyone wants general prosperity.
  • Large majorities want more government spending on popular programs.
• Voters want conflicting policies: Lower taxes, less debt, and new programs.
  • Lower taxes means less spending or more debt.
  • More spending means higher taxes or more debt.
• Key is to raise taxes on “other people.”
  • “Other people” are always a minority of voters (cigarette smokers, affluent voters).
  • For example, fund new medical research with tax on cigarettes
• What caused the recession?
  • Federal Reserve Bank lowered interest rates.
  • Firms developed new methods for selling mortgages.
  • The government reduced credit requirements for lower income families so that they could put a smaller deposit on a mortgage.
  • Cheap money, combined with these new “subprime” mortgage instruments, produced a housing boom.
  • Investment banks began bundling mortgages together combining secure with subprime, or less secure, mortgages and selling them as “mortgage-backed securities.
  • Stimulated home sales
  • Increased book value of homes
  • Homeowners borrowed against increased value of their homes.
  • Homeowners used this equity to buy goods and services within the economy that stimulated economic growth.
  • Debt levels for consumers and banks increased.
  • Banks continued to loan money, increasing their vulnerability to any downturn in the value of the real estate market, which was being used to secure the loans.
  • The economic moved into a recession, in part stimulated by increasing fuel costs. Global production costs increased for goods and services, which led to decreased sales.
  • Many homeowners caught in the economic downturn found the estimated value of their real estate had dropped below the value of their mortgages. Many defaulted on their loans.
  • Banks that held these mortgages were told by federal regulators to revalue their holdings. Investors in the banks withdrew their holdings. Many banks and investment companies that supported them could not afford to maintain payments on these investments, so they failed.
  • Consumers’ and investors’ confidence in global economic markets plummeted. Credit markets froze. This led to reduced economic activity and layoffs, which spiraled into a recession
  • Government policy exacerbated this economic crisis.
  • Two government-backed corporations, Fannie Mae and Freddie Mac, owned $5 trillion in mortgages.
  • They were actually owned by private investors.
  • Widespread belief was that they would be backed by the federal government.
  • They had mandated that banks issue subprime mortgages to poor people. Many of these people were forced to default on their mortgages, which they could not afford.
  • The federal government took over the bankrupt Fannie Mae and Freddie Mac.
  • Credit Froze
  • Banks afraid of an economic collapse stopped lending money to preserve their existing capital reserves.
  • Industries that relied on credit to finance purchases of their product, home builders, and automobile companies experienced drastic reduction in sales.
  • The collapse of these two market sectors rippled through the remaining sectors of the economy, resulting in widespread reduction in economic activity.
  • Unemployment rose as firms laid off workers whom they did not need, due to reduced production demands.
  • The stock market, reflecting these economic changes, collapsed.
  • U. S. Securities and Exchange Commission brought charges against investment banks for manipulating subprime mortgages.
  • 2009 Congress passed Wall Street Reform and Consumer Protection Act. This reinstituted regulations that had been removed in 1999.

Economic Theories and Political Needs:

• Presidents select economic advisors whose theories reflect the president’s own economic views.
  • Conservatives tend to emphasize monetarism and supply-side approaches to economic management.
  • Liberals tend to focus on Keynesianism combined with elements of a planned economy.
• Montarism
  • Asserts that inflation occurs when there is too much money chasing too few goods (Milton Friedman)
  • Advocates increasing the money supply at a rate about equal to economic growth and then letting the free market operate
  • To combat a recession, monetarist supports cuts in interest rates by the Federal Reserve to stimulate borrowing, which in turn stimulates purchases by consumers, coupled with expansion of business financed by lower interest rates.
• Keynesianism
  • Argues that government should create the right level of demand
  • Assumes that the health of the economy depends on what fractions of their incomes people save or spend
  • When demand is too low, government should pump money into the economy by spending more than it collects in taxes.
  • When demand is too high, government should take money out of the economy by increasing taxes or cutting expenditures
• Planning
  • Asserts that the free market is too undependable to ensure economic activity
  • Government should plan parts of a country’s economic activity.
  • Wage-price controls (John Kenneth Galbraith)
  • In 2008–2009, the federal government began to invest in failing banks. Some planners asserted that the government should assume control of Bank of America and Citibank in order to recover federal investments.
• Supply-side tax cuts
  • There is a need for less government interference in the market and lower taxes.
  • Lower taxes would create incentives for work and investment.
  • Greater investments lead to more jobs.
  • Increase in productivity will produce more tax revenue for the government.
• Did the federal government end the recession?
  • Proponents of the 2009 stimulus law argued:
  • Stimulate consumer activity by giving the public money.
  • Spend more money on state, local, and federal projects to create jobs.
  • Pay for these programs through increased federal borrowing.
  • Republicans in Congress opposed these measures.
  • It would take two to three years for government projects to stimulate the economy.
  • Borrowing this money would increase the federal debt.
  • Tax cuts would have the same impact by putting more money into the hands of consumers and businesses.

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