TOPIC16Macro-economic Policy The Effectiveness of Fiscal Policy Fiscal Policy and the Public Debt |
Despite
the commitments of governments to stabilize their national economies at
something like full capacity output and stable price levels, both unemployment
and inflation became familiar terms to residents of the industrial democracies
in the decades following World War II. Since the end of World War
II, unemployment and inflation data have become widely-accepted indicators
of a country’s economic performance and governments have come to be held
responsible for ensuring that unemployment and inflation rates are kept
within acceptable bounds. Elected officials with a bad record in this respect
face trouble at the next election. Yet both terms, for all their familiarity
and the importance attached to them, are much more difficult to handle
with precision than might be thought. This has been particularly evident
in the years since the early 1970s. Until then it was not too difficult
to accept the modified Keynesian position that deficiencies in aggregate
demand would lead to unemployment whereas excessive levels of aggregate
demand would generate inflation. But in the early 1970s all the industrialised
countries began to experience, in varying degrees of severity, high and
rising levels of unemployment and rising levels of inflation at the same
time. This phenomenon, which came to be referred to as "stagflation," led
to great confusion and uncertainty both within and outside the ranks of
professional economists. The few who had never been comfortable with the
Keynesian position were quick to proclaim that Keynesianism had failed,
both as an explanation of how the world worked and as a basis for useful
policy solutions. In its place, some began to offer explanations and policy
prescriptions based not on aggregate demand, but aggregate supply.
As commonly used, the term unemployment refers to would-be workers being out of work, a condition generally assumed to be undesirable. One of the great virtues once claimed for Soviet style central planning was that such a system eliminated the scourge of unplanned, market economies by doing away with unemployment and all the uncertainty and personal difficulties associated with the risk of losing one’s job. But the cost of such a rigid system was that many workers were assigned to jobs for which they will ill-suited, it was often difficult to change jobs, there was little incentive to seek more productive employment, and employers could only with difficulty dismiss unproductive workers. But there was job security and most people who could work did indeed have some kind of employment, however unproductive it might have been. The capitalist market economies by contrast have had much more flexible arrangements for getting workers into jobs. Within limits imposed by law and negotiated contracts, workers have typically been free to move from one job to another, employers have been free to hire and fire, and businesses have been free to fail or succeed. Consequently, in such economies, some part of the available work force is always in the process of changing jobs, sometimes voluntarily, other times not. There is also a constant movement of people into and out of the work force—young people looking for their first job, older people retiring, women leaving the work force to start families and perhaps subsequently re-entering the work force. The amount of this kind of unemployment may vary considerably from time to time. There may be a great deal of it during periods when a burst of technological development alters the demand for certain kinds of labour, or when demographic developments alter the age or sex composition of the source population, or when there is much industrial restructuring going on as a result of shifts in world trade patterns. Economists tend to view such frictional unemployment as being for the most part benign, although attention may be given to finding ways to improve the efficiency of labour markets so that they handle such adjustments more smoothly: labour-exchanges and other agencies which provide workers and employers with better and more timely information about vacancies and labour availability, education and retraining programs are examples. The same may be said of seasonal unemployment which results from predictable changes in the demand for labour in certain employments over the course of the year. It may be possible to help workers adjust to job availability or find alternative seasonal work, but it is unlikely that all such fluctuations could or should be eliminated. Consequently, it seems, in any free market economy there will be some normal, irreducible, or "natural" rate of unemployment. The type of unemployment which creates a much more serious set of social and economic problems is the kind that results from a deficiency of aggregate demand. Large-scale involuntary unemployment which comes about when a significant portion of the labour force cannot find jobs despite the desire to do so is the kind of unemployment that imposes severe costs on individuals and society at large. Individuals caught in such a condition suffer loss of income, and often experience a loss of self-esteem and social status. The community as a whole suffers a loss of real output which can never be recovered. If severe enough, large-scale involuntary unemployment can create social and political instability. Clearly, it would be desirable to reduce involuntary unemployment if it were possible to do so. The Keynesian view suggests that it is indeed possible and indicates how it might be done. But many difficulties stand in the way of getting a consensus with respect to both diagnosis and treatment of this condition. One of these difficulties has to do with separating the two general types of unemployment just identified. Only part of the total population, of course, is available for employment. That part, the labour force, is mainly in employment at any given time. Every developed country has official estimates of the total amount of unemployment, usually arrived at by conducting a regular sample survey of the population to determine the work status of those surveyed ("employed," "unemployed but seeking work," "temporarily laid off, but expecting to be recalled," etc.) The unemployment rate is the percentage of the labour force which at the time of the survey is unemployed. But what part of the measured unemployment is due to frictional forces and what part is due to deficient demand? It might be thought that this is a simple question which could be settled by empirical investigation, but unfortunately this is not the case. Economists remain sharply divided over how to interpret the evidence on this issue. Expert opinion on the matter can be divided into two main camps, each containing several factions. Some economists believe that the natural rate of unemployment in most developed economies is quite low and relatively stable as a percentage of the labour force. They tend to see most unemployment as being caused, consequently, by deficiencies in aggregate demand. This position is supported by studies which demonstrate a strong positive correlation between changes in the level of real GDP and changes in the unemployment rate. The policy implication is straightforward: aggregate demand should be maintained at levels high enough to keep the economy operating near its capacity. If the productive capacity of the economy is expanding over time, as was the case in all the industrial countries through most of the post-World War II period, it would be necessary for aggregate demand to grow at a corresponding rate. If it failed to do so, unemployment would rise above the natural rate. During the 1960s and 1970s in the United States, for example, it was estimated that demand and real GDP had to grow at a rate of at least 3 per cent per annum to keep this from happening. The opposing view is that the natural rate of unemployment accounts for a relatively large percentage of total unemployment and that, rather than being stable, the natural rate may vary considerably over time. Evidence in support of this interpretation is found in correlations between changes in the unemployment rate and such things as the volume of inter-industry shifts of labour resulting from technical change, changing trade patterns and the like. These differences with respect to the relative importance of the natural rate of unemployment are reinforced by disagreement among economists over the functioning of labour markets. Suppose a full-time worker on a car assembly line has been earning $20 an hour. Now the worker is laid off, becoming "unemployed and seeking work." After several weeks of looking for a job (ignore unemployment insurance benefits for the moment) the worker is offered a job similar to the old one, but at $1 an hour. Would this be acceptable? If not, it would seem that the worker should now be considered voluntarily unemployed and, if there were many such cases, the unemployment rate would decline. But perhaps this example is unrealistic. After all, if the wage rate for factory workers fell from $20 an hour to $1, surely other prices must have fallen too. In that case, the real wage rate is more than $1. Indeed, if the prices of all the things such workers would normally buy fell by the same percentage as the money wage, they would be just as well off at $1 an hour as they were before. Is this how the real world works? Keynesians think not. In their view, prices and real wages are not flexible downwards to such a degree that all unemployment becomes, in this sense, "voluntary". The policy implications of this debate are important. If most unemployment is natural, then remedies for unemployment that involve trying to raise aggregate demand are not only futile, but probably pernicious—for reasons to be considered in the next section. Other measures, such as those mentioned earlier to improve the efficiency of labour markets, may be called for, although it may be difficult to assess their benefits relative to their costs. If most unemployment is caused, directly or indirectly, by a deficiency in aggregate demand, then the Keynesian remedy is appropriate—spending must somehow be increased. The example of a
drastic reduction in wages just given avoided the complication of unemployment
insurance or other benefits which might cushion workers against the full
impact of becoming unemployed. Is it possible that such provisions may
cause unemployment to be higher than it otherwise would be? Evidence from
a number of different countries suggests that the answer is yes, although
the magnitude of the influence varies greatly depending on the design of
the system. In the context of the present discussion the significance of
such programs is that they have some effect on the natural rate of unemployment
by making it easier for workers to remain longer between jobs, or to depend
on seasonal rather than more stable employment. Reducing or eliminating
such programs might consequently reduce the natural unemployment rate,
but any such benefit would have to be weighed against the costs of exposing
workers to greater hardship from job loss.
If all prices and incomes rose equally, no harm would be done to anyone. But the rise is not equal. Many lose and some gain. —Irving
Fisher (1920)
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Inflation has already been defined as a rise in the general price level and the GDP deflator has been introduced as a measure of it. The inflation rate is defined as the percentage rise in the price level over some period of time, such as a year. Are fluctuations in the general level of prices a problem? The question here does not refer to changes in particular prices, but a change in all prices. Changes in relative prices are essential elements in the operation of a market economy, reflecting as they do changes in demand and supply conditions and signalling firms to produce more or less of particular goods, influencing the decisions of consumers as to which goods to substitute for others, allocating scarce factors of production to different uses and so on. Such price changes as these have nothing to do with inflation. What significance should be attached to a rise or fall in the general level of all prices? Probably very little if such changes are uniform throughout the economy and if everyone has an equal opportunity to adjust to them. The problem with inflation is that these conditions are not met in the real world. Changes in the general level of prices may cause an unwanted redistribution of income in society, the extent of which will depend on the ability of individuals to anticipate the direction and extent of changes in the general price level and their ability to make the necessary adjustments in their spending, saving and investment decisions to avoid being made worse off by them. The ability of people to adapt to inflation was well demonstrated during the period of rapid inflation touched off by the OPEC oil price shocks of the 1970s. The potential gainers from such inflation are borrowers, who find themselves repaying loans in money which has fallen in value relative to what it was worth when they borrowed it. The losers are creditors who get back money worth less than when they loaned it. The subsequent behavioural adaptation of lenders to such experience was, of course, to refuse to lend money unless the interest rate paid for its use included whatever additional percentage points were needed to offset the expected rate of inflation over the life of the loan. Other potential losers from inflation are workers who negotiate wage contracts on the assumption that their money wages will continue to buy as much at the end of the contract as when it began. The adaptive response of workers in this situation was to build into their wage demands amounts calculated to keep annual money wage increases high enough to offset the effect of expected increases in prices. Other groups, such as pensioners, had to use what bargaining power they possessed to induce those in charge of their plans to index pension payments to the cost of living. Learning to live with inflation by adjusting behaviour to take its effects into account unfortunately tends to perpetuate the condition. Anticipating inflation by indexing pensions, incorporating an inflation premium into interest rates, building cost-of-living clauses into wage contracts makes the expectation of inflation a self-fulfilling prophecy. Recalling the aggregate supply relationship, building inflationary expectations into factor prices pushes the short run aggregate supply schedule up in what could be a cumulative process leading to continuous or, under certain assumptions, even accelerating inflation. High or accelerating rates of inflation increase uncertainty and make anticipating the future even more difficult. The prospect of a hyper-inflation, with prices increasing so rapidly as to destroy confidence in the currency, is an economic nightmare which has fortunately turned into reality only occasionally, as in the German experience after World War I, when the rate of inflation reached rates of several thousands of per cent per month in the fall of 1923. Historically, inflation has been associated with war and an increase in the money supply. The two have gone together because, faced with the question of national survival, governments at war have always been able and willing to resort to increasing the money supply to meet their spending requirements, rather than rely on extracting the necessary funds from the citizenry by means of taxes or borrowing. Even the modern experience with inflation, particularly in the 1970s, had some connection with war, including the Arab-Israeli conflict in the late 1960s and the ensuing OPEC oil crises, the American war in Viet Nam and, of course, the arms race between the US and the Soviet Union. Whether induced by war or other causes, increases in the money supply appear to be necessary for inflation to persist. The way the money supply and the price level are related may be modelled in different ways. A traditional statement of the relationship is provided by the venerable quantity theory of money which enjoyed a renaissance when it was resurrected by Milton Friedman, leader of the so-called Monetarist school of economics in the 1960s. In one of its many formulations, the quantity theory held that if the quantity of money in existence was multiplied by the frequency with which it was spent, the total would be equal to the physical output of goods and services in the economy multiplied by the price level. In short, MV=PT (where M is the money supply, V is the velocity of circulation, P is the price level and T is the number of transactions). Assuming that V is a fixed rate (on average people respend money they receive at about the same rate over time) and that T is fixed (the volume of transactions is limited by the physical capacity of the economy to produce goods and services), then any increase or decrease in M must result in an equal increase or decrease in P. The implication of
this with respect to inflation, a rise in P, is clear. If the velocity
of circulation is indeed constant and if the economy is producing at full
capacity, unless there is an increase in M there can be no inflation. Professor
Friedman and his followers used this to attack Keynesian economics, contending
that the evident failure of Keynesian aggregate demand management policies
to control inflation in the 1970s was due to the fact that it was the money
supply, not aggregate demand, that was driving inflation. This "monetarist"
approach appealed to the new conservative movements led by Margaret Thatcher
in the UK, Ronald Reagan in the US, and their counterparts in several other
developed countries who were faced with the task of bringing inflation
under control.
There is perhaps no other empirical relation in economics that has been observed to recur so uniformly under so wide a variety of circumstances as the relation between substantial changes over short periods in the stock of money and in prices; the one is invariably linked with the other and is in the same direction; this uniformity is, I suspect, of the same order as many of the uniformities that form the basis of the physical sciences. —Milton
Friedman
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The remainder of this topic is devoted to setting out some key developments on both fronts. Using the government budget to shift the equilibrium level of national income toward a non-inflationary full employment position is conceptually simple. If there is a deficiency in aggregate demand as a result of the spending wishes of the consumers and private investors falling short of the full employment level of real national income, the government could spend in excess of its revenues, thereby raising total planned spending and ultimately, with the help of the multiplier effect, the level of real GDP. Early Keynesian economists often wrote and spoke as if such a government supplement to private spending might have to be a more or less permanent feature of modern capitalist economies. With the experience of the 1930s still fresh, there was a suspicion, shared by many students of modern capitalism at both ends of the political spectrum, that the system had an inherent tendency to run down. This was expressed formally by one of the earliest academic converts to Keynesianism in the US, Alvin Hansen, who speculated that the maturing of capitalism in the United States would lead to a slowing of population growth as the birth rate declined, as opportunities for expansion into new regions disappeared, and as the accumulation of capital stocks caused profits to dwindle. Without some outside intervention, modern capitalist economies seemed destined to slide into what Hansen called "secular stagnation." Given the prevalence of such concerns, Keynesians in the 1940s were not unhappy to see large new social welfare and other government spending programs becoming popular with the electorate. Even if these were financed by taxation, they were likely to result in income transfers from the relatively well-off to the poor, transfers which would shift income from persons with low to those with high marginal propensities to consume. Similarly, transfers from rich regions to poor regions could also help discourage any tendency for consumption spending to fall. These programs had the added feature of being automatically activated and the amount of spending increased if the level of employment and income in the economy fell. Payouts from unemployment insurance plans and various welfare programs would increase at such times and decline when the economy was more buoyant, acting as built-in automatic stabilisers. As for direct government spending on goods and services (including capital goods), there was concern that the end of World War II would precipitate a new depression as government military spending was cut back. In fact, however, particularly in the US, which emerged from the War as the economic and military super-power of the western world, large-scale defence spending continued as a result of the "cold war" with the Soviet Union and specific engagements such as in Korea and Viet Nam. Major publicly-supported investments in social capital, such as national highway networks, electric power and irrigation projects also became common throughout the rapidly expanding industrial nations. By the 1970s there was no shortage of ways for governments to increase spending if they had reason to do so. As the great post-World War II economic expansion continued, however, there was growing unease about this expansion of government activity in the economy and the growth in public spending associated with it. One specific problem was that, as noted above, unemployment began to rise in many of the industrial countries despite historically high levels of government spending. Worse, in the 1970s, an unprecedented peacetime inflation initiated by the OPEC oil crises showed signs of spiraling out of control. Along with this was a renewal of concern about the growth of the public debt. Although much of the increase in the public debt in the 1970s and 80s was simply the consequence of inflation, public attention began to focus on this previously largely ignored statistic. The fiscally conservative began to voice concern that government spending, financed by borrowing, was leading to a dangerous build-up of the public debt. By the 1980s there were at least two big issues relating to the use of fiscal policy: how effective it was and, whether effective or not, was it leading to an unacceptable level of public indebtedness? The Effectiveness of Fiscal Policy One of the claims made by the Monetarists and other critics of Keynesian aggregate demand management policy was that increasing government spending merely transferred spending from the private sector to the public sector, with the result that there is no net increase in total spending. If this was so, the Keynesian strategy of manipulating aggregate demand was doomed to failure. How this crowding out effect of public spending worked, the Monetarists argued, involves the way increased government spending affects interest rates. When governments increase spending on goods and services (or if they reduce taxes) there is an increase in the total planned spending in the economy. This puts upward pressure on interest rates which in turn causes the level of (private) investment spending to fall. This reduction in investment spending may completely negate the initial effect of an increase in government spending (or reduced taxes) on aggregate demand. The Keynesian reply to this reasoning was that it rests on a mistaken assumption about the relationship between interest rate changes and changes in the amount investors will plan to invest. As we have already seen, In the Keynesian view, private investment spending is not very responsive to changes in interest rates, with the result that the effect of a change in interest rates (however caused) will have relatively little effect on investment spending and consequently little effect in offsetting the initial impact of increased government spending on goods and services (or reduction in taxes). This particular issue has now been largely resolved. Careful empirical studies in a number of different countries show that, while investment spending is affected by interest rates, the effect is not very strong. It would seem, then, that fiscal policy can indeed have an effect on aggregate demand, although it may be offset to some extent by a negative impact on private investment spending. The National Debt represents the savings of the poorer classes, rather than the money-bags and coffers of the rich and luxurious. —William
Stanley Jevons (1884)
Fiscal Policy and the Public Debt Government spending can be financed either by taxation, or by borrowing (issuing government bonds). Taxing ensures that spending decisions are influenced by the willingness and ability of productive members of the community to support them. At inflationary levels of national income taxation can serve to reduce aggregate demand by removing spending power from the private sector. If the economy is depressed, however, financing spending by taxation eliminates the stimulative effect such spending may have. From a micro-economic perspective, taxes distort the allocation of resources in the economy, discouraging the production of taxed goods, or more heavily taxed goods, relative to other goods. There may also be disincentive effects if, as is likely in modern nations, the taxes bear upon or are proportional to income. From a political perspective, taxes cost votes. To the extent that government spending is not tax financed, it must be debt financed. Government must borrow the funds needed to close the gap between current tax revenues and current government spending. A balanced budget is one in which expected tax revenues and planned spending are the same. If revenues exceed spending, there will be a surplus—the government will be saving. If spending exceeds revenues, the government is dissaving, and going into debt. Over what period of time should this reckoning of the balance be carried out? For reasons of administrative convenience or convention, most government budgets are calculated on an annual basis, over some arbitrarily defined fiscal year. Prior to Keynes, it was generally assumed that in peace-time governments should try to balance their budgets, at least with respect to current spending. The financing of public investment, such as building highways or the like, was sometimes financed by issuing government bonds, but such activity was relatively unusual except in young developing countries like the British "dominions" in the 19th century where a good deal of government-financed or government-supported investment was part of the nation-building process. Opposition to government debt finance probably stemmed from an analogy between private personal finance and public finance. Going ever deeper into debt to finance current spending in excess of current income was the road to personal ruin, leading ultimately to bankruptcy and debtors’ prison. Would this not also be the fate of a nation that financed government spending by permitting an ever-increasing public debt? Another traditional concern with public borrowing was the issue of inter-generational transfers of income. Can one generation pass the burden of its spending on to later generations? Can going into debt to finance the production of goods today impose a burden on future generations who will have to pay off the debt incurred now? In countries like the UK, where some of the public debt goes back several centuries, is it fair that a taxpayer today should still be paying taxes so that the government can pay interest on debts incurred to fight a war in the 17th century? Keynes and his early followers recognised that these traditional concerns about the public debt could stand in the way of winning acceptance for their strategy of using deliberately unbalanced government budgets to maintain aggregate demand. What was important to them was that the economy be in full employment equilibrium, not that the government’s budget be balanced. As William Beveridge, the chief architect of the British welfare state in the 1940s put it, the government’s budget should be considered balanced when there is full employment in the economy. In the US, an early Keynesian, Abba Lerner, argued that the traditional analogy between private and public debt was simply wrong-headed. The public debt, Lerner insisted, is something we "owe to ourselves." If the government sells a $10,000 savings bond, for example, to citizen A, it pays interest to citizen A. If it taxes citizen B to pay citizen A his interest, all that is happening is that income is being transferred from a taxpayer to a bond holder. Taking a collective view of such transactions implies that there is no net social loss or burden created, only a redistribution of income. Whether such a redistribution is good or bad is another issue, as discussed earlier. Lerner and other Keynesians also argued further that it is simply not possible to shift the real burden of public debt onto future generations. Public spending today leads to resources being used up now, however this spending is financed. If there is any "burden" associated with this it is borne by those people living today who are foregoing current consumption. For example, suppose that during a war governments spend heavily to manufacture bombs which are used to blow up enemy cities, and the production of these bombs is financed by borrowing. The real, alternative opportunity cost of these bombs must be borne by those who were denied whatever else could have been produced (private household appliances, perhaps) with the labour and other resources committed to bomb production. In this sense the cost of World War II was borne entirely by the generation then alive. Their children may have inherited tax liabilities required to service whatever may remain of the old war debt, but again, this is merely an income transfer among taxpayers and holders of the remaining debt. There is no inter-generational transfer of a burden, only a redistribution of income among members of the same generation. The real wealth of the nation in the next generation is unaffected. The case made by conservative critics of attempts by Keynesians to downplay the real economic effects of public borrowing rests largely on the contention that debt financed public spending must eventually entail taxation to service and ultimately retire the debt. There is consequently an appropriation by the government of the individual citizen’s freedom to choose how income is allocated among purchases of different goods and services. The root disagreement in this case is the extent to which there are collective needs that should be given priority over the particular preferences and priorities of individuals. A similar argument may be made about the fairness of transfers of debt responsibilities to future generations. While there may be no real economic burden associated with imposing higher tax requirements on future generations, there is a possibility that some individuals today will benefit more than others from a policy of debt rather than tax financing. Even if all one generation can pass on to another is the need to have a larger flow of income transfers to service the public debt, some individuals in the generation alive today (the childless, for example) may find this less objectionable than others. This is only saying, however, that some of the present generation may be more or less concerned about the redistribution inflicted on future generations, not about any real burden being passed on to them. The debate between Keynesians and Monetarists and their successors over monetary policy is based on a fundamental difference with respect to the way changes in the money supply affect the level of real economic activity. As we have already seen, Monetarists see a direct link, Keynesians only an indirect one. The practical implications of this difference have to do with the possible effectiveness of monetary policy as a device for stabilizing the economy. The extreme position on the Monetarist side would suggest that only monetary management is required to keep the economy stable. And even this would not be very active management, for if the economy is expected to operate automatically at a full capacity level of output, all the monetary authority must do is increase the money supply at whatever rate is required to keep up with the growth in productive capacity over time. The strongest position on this is that no discretionary policy of any kind would be needed. The monetary authorities could simply be provided with some rule to follow to ensure that the economy does not suffer from a lack of monetary lubrication. The extreme position on the Keynesian side was equally straightforward: for many Keynesians it seemed evident that "money doesn’t matter." Just as the extreme Monetarist would claim that the real side of the economy can operate perfectly well on its own without outside interference, so the extreme Keynesian would argue that the money supply can look after itself—indeed, some have argued, it cannot be managed. The supply of money, in this view, is not something which can be managed in the ways suggested in Topic 13 it is, rather, determined inside the economy. (The money supply is determined endogenously, internally, rather than exogenously, as by a central bank—independent of what else is going on in the economy.) Those who take this position believe that modern financial institutions function in such a way that the supply of money is largely determined by the demand for money. When Monetarists point to the obvious correlation between changes in the money supply and changes in the level of real economic activity as evidence that the money supply is a potent influence on the level of real economic activity, they are simply getting the causal relation the wrong way around. The reason there is such a correlation, the Keynesians argue, is because increases in the level of real economic activity bring about an expansion of the money supply, while contractions reduce it. Policy makers appear to be influenced for the most part by more moderate theoretical positions falling between these extremes, utilising the power of central banks to ease or restrict credit conditions and adjust interest rates down or up depending on the need to stimulate or restrain aggregate demand. There has been, however, one interesting period in the history of macroeconomic policy when a strong monetarist strategy was tried out by several major central banks. In the late 1970s the Bank of England, the US Federal Reserve, and the Bank of Canada all appeared to have fallen under the Monetarist influence and implemented a policy of trying to keep the growth of their domestic money supplies within a certain targeted growth range. The results were disappointing. None of these banks succeeded in controlling the broad monetary aggregates they were targeting. Different reasons were cited in different countries, but since the early 1980s nothing has been heard of plans to repeat the exercise. Monetarists explained the failure by claiming that the banks had chosen the wrong aggregates to target or that they had simply mismanaged the operation. Apart from this episode, monetary policy in the industrial countries has operated as if guided by a compromise between the Keynesian and Monetarist extremes. The central banks have exercised control over commercial bank reserves through open market purchases and sales of government securities, transfers of government accounts and sometimes by using other instruments such as adjusting the legally required reserve to deposit ratios. The ability of central banks to manipulate interest rates, particularly through open market purchases and sales of government bonds, has been well demonstrated. There is a simple direct correlation between bond prices and interest rates which this technique exploits. When a central bank enters the bond market and aggressively buys bonds it not only increases the cash reserves of the commercial banks (as described in Topic 13), it also exerts an upward influence on the price of bonds. If, instead, it sells bonds, bond prices will fall. This may be a matter of great interest to speculators in bond markets, trying to guess whether the central bank is going to position itself as a net buyer or seller, for there are obvious opportunities to profit from such a guess if it is correct. But more important is the effect of changes in bond prices on interest rates. The relationship is inverse. A rise in bond prices will be associated with a fall in interest rates, a fall in bond prices with a rise in interest rates. The reason is straightforward: if an existing $1000 bond bearing interest at 5% could be purchased for only $900 the buyer would earn more if the bond were held to maturity than if it had been necessary to pay $1000 for it—the bond’s yield (interest plus the difference in its face value and the price paid for it) would be higher at the lower price. If bond prices fall and the yield on existing bonds increases in this way, issuers of new bonds will have to offer a comparable return—new issues will bear an interest rate competitive with yields on existing bonds. How drastically central banks can manipulate the availability and price of credit was demonstrated in the early 1980s when the Federal Reserve in the US, supported by other major central banks, forced interest rates up to unprecedented levels and kept them high long enough to break the pattern of inflation which had developed over the preceding decade. Unfortunately, this victory over inflation was accompanied by the most severe fall in output and employment since the 1930s. The experience with monetary policy consequently leaves open the question of its overall effectiveness as an instrument of stabilisation policy. Evidently, if used with sufficient severity it can be a potent, if perhaps excessively blunt, instrument. Whether or not it can be effective in moderating milder fluctuations remains debatable, particularly in the case of the smaller national economies. One of the great hopes for macroeconomic policy in years following World War II was that it would enable people to exercise control over their own economic destinies. This implied an element of collectivism, in that there was necessarily a transfer of some decision-making from individuals to the government acting on their behalf. By the 1980s this collectivist solution was under attack from conservatives bent on checking the growth of government’s role in the economy and, as just seen, this ideological conflict is reflected in the debate over the theoretical foundations of macroeconomic policy. In the late 20th century another influence was impinging on the domestic economic policy-making process in all the developed countries, the increasing ease of large scale financial and other economic transactions among nations. Domestic Economic Policy and the International Environment Trade in goods and services and the international movement of financial assets effectively link economic activity in one country to what is going on in the rest of the world. Countries that have a large trade component in their national income will be strongly affected by fluctuations in world demand for their exports. A drop in demand in a key export market will quickly translate into reduced output and job losses in the export industry directly affected, and these effects will be transmitted throughout the economy as a consequence of the kinds of interrelationships explored when the multiplier effect was considered in Topic 15. Financial markets are also closely interconnected. Improvements in communications technology have made it possible for traders in financial assets to respond almost instantaneously to opportunities created by differentials in interest rates in different countries. This can make it very difficult for a particular country to keep its domestic interest rates at a level consistent with considerations of both domestic and international stability. Much of any country’s adjustment to changes in the international environment is reflected in the value of its domestic currency as determined in the foreign exchange markets. As seen in Topic 11, exchange rates fluctuate in response to shifts in the demand for a particular currency relative to the amount of it supplied. Such fluctuations are often interpreted as an indication of how successfully the economy is performing. If the popular press is any indication of public opinion in this respect, it seems that most people feel good if their domestic currency is rising in value on the exchanges and unhappy if it is falling. Exchange rate fluctuations do have a particular significance for particular groups in the domestic economy. People about to go travelling abroad obviously lose if the value of the domestic currency falls relative to foreign currencies. But, more important, exporters will benefit from a fall in the value of the currency because the effect is equivalent to a reduction in the price foreign buyers have to pay for their output. On the other hand, importers suffer because a fall in the value of the domestic currency has the effect of making imports more expensive. Exchange rate fluctuations also affect international capital movements. Anyone contemplating investing in physical assets abroad, or in purchasing financial assets denominated in a foreign currency must take into account possible fluctuations in the relevant exchange rate. Assessing the profitability of acquiring bonds issued by foreign businesses or governments, for example, requires considering their yields after converting them through the exchange rate to values in the domestic currency. A change in the exchange rate could have a dramatic effect on the income earned from such an investment. Attempts to restructure world economic arrangements at the end of World War II included an agreement among the developed nations to implement a system of fixed exchange rates which, it was hoped, would promote greater stability and reduce the kind of uncertainty which was blamed for the difficulties of the interwar period before 1939. Each country’s central bank was expected under this plan to intervene in foreign exchange markets to maintain its domestic currency within some agreed range of values relative to other currencies (in effect, the US dollar). This meant that central banks would have to enter the exchange markets to buy the domestic currency when it threatened to fall below the pegged rate or, if it threatened to appreciate to a higher value, offer enough of it for sale to bring the market price down into the desired range. Many countries found it difficult to live up to this agreement. Domestic monetary policy often had to be sacrificed to maintain the pegged exchange rate. When a central bank had to buy foreign exchange to counteract market forces threatening to force the exchange value of its domestic currency up, this inadvertently caused the domestic money supply to expand because the sellers of the foreign currency would receive, in effect, cheques drawn against the credit of the central bank, which would then be deposited in commercial bank accounts. This was equivalent to the process by which open market operations could be used to expand the reserves of the commercial banks, encouraging them to expand credit, and ultimately causing interest rates to fall. If upward pressure on the domestic currency in the exchange markets coincided with deficient domestic aggregate demand, this was no problem. But if it came at a time when the central bank wanted to "cool down" the domestic economy by raising interest rates and restricting the availability of credit it rendered such domestic policy measures ineffective. Conversely, if the domestic currency was under downward pressure and it was threatening to depreciate below the agreed value, the central bank would have to sell foreign exchange which would reduce commercial bank reserves and lead to a contraction of domestic demand. Again, whether this would be desired would depend on the circumstances. Under fixed exchange rates, particularly in the 1960s, most of the industrial countries experienced very similar rates of inflation, and changes in interest rates in one country were soon matched by corresponding changes in interest rates in the other countries. The reason for this was that with fixed exchange rates, price changes in one country would quickly be matched by corresponding price changes in its trading partners because of the activities of traders specialising in international arbitrage, buying goods where their prices were relatively low and selling them where their prices were high. To the extent goods could be moved among countries without restriction, and given that currencies did not fluctuate in relative value, such trading operations would ensure that the prices of goods would fall in the high price countries and rise in the low price countries due to the simple forces of market supply and demand. Similarly, the prices of financial assets would be subject to the same mechanism. If bonds fell in price in one country relative to the price of similar bonds (similar in terms of risk, liquidity, etc.) in other countries traders would quickly begin trying to buy up bonds in the cheap market to resell them in the more expensive markets. Again the prices in the several markets would soon be equalized. Thus, changes in interest rates and in inflation rates tended to follow the same pattern throughout the international economy. This is not to say that all differentials were eliminated under the fixed exchange rate system. Not all goods are tradable. Tariffs and other impediments to trade, differences in the riskiness of investments and so on could prevent a perfect harmonisation of price and interest rate movements among countries. But in broad terms, the key economic rates and aggregates tended to move in lock-step under fixed exchange rates. Critics of the fixed exchange rate system of the 1950s and 60s complained that it unduly limited the ability of individual countries to pursue their own preferred macroeconomic strategies. They could also point out that, while eliminating many of the short term fluctuations and uncertainties which would otherwise exist in exchange markets, the fixed rate regime created the possibility of periodic exchange rate "crises." During periods when a central bank had to buy foreign exchange to keep its currency from appreciating, it incidentally built up the country’s official foreign exchange reserves. When it had to pursue the opposite policy, of dumping foreign exchange into the market to support the domestic currency, it tore down these reserves. At such times, speculators in exchange markets were kept busy trying to guess how long a country’s foreign exchange reserves could hold out before the authorities had to abandon their support of a beleaguered currency. Particularly in Britain in the 1960s such exchange crises proved troublesome. Not surprisingly, many economists came to the view that it would be better to allow the free market to rule in international exchange as in other areas of economic activity. When drastic changes in US foreign economic policy occurred in the 1970s, the fixed exchange rate regime crumbled and was replaced by a system of "almost free" exchange rates. (The qualification is needed because, while most central banks abandoned the idea of maintaining their currency in a narrow range of values relative to other currencies, they continued to use their influence in exchange markets to smooth out relatively minor fluctuations in the rates.) Another important qualification is that many countries were at that time banding together into trading blocs. This went furthest in Western Europe where the major industrial countries created the European Monetary System which commits all the member nations to maintain their domestic currencies within specified ranges of values. The result has been that interest rates and inflation rates throughout Western Europe change in harmony with one another and the autonomy of member nations to manage their own economic affairs has been correspondingly constrained. The direction of monetary policy in particular has come to be determined by the policy positions of the strongest of the European central banks, particularly the Bundesbank of integrated Germany. But even in Western Europe, with its apparently firm resolve to foster economic unification, this loss of national sovereignty with respect to the making of economic policy has met considerable resistance. The experience with flexible rates has disappointed many who expected the new regime to increase national macroeconomic independence. It was soon evident that the ease with which the effects of interest rate changes and other changes in key macroeconomic variables could be detected and acted upon left no country, not even the US which had earlier seemed likely to become a kind of world banker issuing an international currency, the American dollar, able to insulate itself from international economic interaction. There has also been a great deal of instability in world financial markets under flexible rates. Theoretically, flexible exchange rates make it possible for permanent differentials in prices and interest rates to exist (beyond those based on trade restrictions and other forces, as noted above). Suppose that even a relatively small country wants to pursue its own independent macroeconomic policy despite close trading and other links with a large country like the US. Suppose further that the US government goes on a spending spree to stimulate the economy prior to a Presidential election. The inflation rate in the US rises. Can a country like Canada avoid having an increase in its inflation rate? With US prices rising faster than Canadian prices, Canadian goods and financial assets become relatively more attractive. In terms of the arbitrage process, Canada becomes a good place to buy and the US a good place to resell. But to buy in Canada it is necessary to acquire Canadian dollars. Unless resisted by the Bank of Canada, the $C will appreciate. This appreciation in the $C will raise the price of Canadian goods and assets in terms of $US and the arbitraging incentive disappears. Exchange rate appreciation can consequently have the effect of disconnecting the mechanism linking Canadian and US price levels. Recall from the earlier discussion of exchange rates, however, that a policy of allowing a currency to appreciate (or depreciate) will not be advantageous to all the economic interests in a country. An appreciating exchange rate may be the price paid for having a lower inflation rate than the rest of the world, but this price will be paid by exporters who will complain that they are being "priced out of world markets" by the high value of the domestic currency. The ability of a country to pursue its own macroeconomic objectives is also affected by the international mobility of financial assets. Especially since the advent of high-speed satellite communications and electronic data processing systems, it has become possible to move funds from one world financial centre to another almost instantaneously. Consequently, if interest rate differentials open up, say between Tokyo and New York, short term capital will be transferred from the country with lower rates to the country with higher rates. Such capital transfers have a potential impact on exchange rates. If capital moves from Japan to the US, there will be upward pressure on the value of the US currency in international exchange markets as holdings of Japanese financial assets are converted into holdings of US financial assets. Such exchange rate consequences of capital movements will in turn have some possibly important effects on domestic macro-economic policies in the countries concerned. Whether these effects are positive or negative depends on a number of considerations, the most important of which is whether or not these countries are trying to maintain some particular value for their currency or are willing to let it find its own value in the exchange markets. When a country is committed to maintaining some specified value for its currency (as in the case of fixed exchange rate regimes), the effect of international capital movements is to weaken, perhaps even negate, the effect of domestic monetary policies. Consider a situation in which a central bank is trying to control domestic inflation by pursuing restrictive monetary policies. (It wants to reduce domestic spending and "cool down" the economy.) To accomplish this it restricts credit and forces interest rates up. This rise in interest rates may, however, attract capital inflows from abroad. These capital inflows will create a larger demand for the country’s currency and the value of this currency on the exchanges will tend to rise. To resist this influence and keep the value of the domestic currency at its desired level, the central bank would have to sell its own currency or, what is the same thing, buy foreign currencies. But buying foreign exchange causes commercial bank reserves to rise (they obtain domestic currency from the central bank — cash reserves — in return for foreign exchange bought by the central bank). This, however, is exactly the opposite of what the central bank set out to do, which was to contract, not expand the domestic money supply. Thus, monetary policy, under fixed (or even "somewhat fixed") exchange rate regimes may be ineffective. Flexible exchange rate regimes on the other hand may reverse these consequences. If the exchange rate is allowed to float freely (a "clean float") domestic monetary policy may actually be enhanced by the exchange rate effects of international capital movements. In the case just described, the rise in interest rates caused by the restrictive monetary policy would attract an inflow of capital. This would exert upward pressure on the value of the domestic currency, reducing exports and encouraging imports. The fall in the value of net exports would contribute to the restrictive effect of the central bank’s monetary policy. Indeed, in countries where domestic investment demand is not very responsive to interest rate changes, the effectiveness of monetary policy may depend more on this net export effect than on any reduction in domestic investment demand. The effectiveness of fiscal policy is also affected by international repercussions and again the consequences vary depending on whether exchange rates are fixed or floating. In general, fiscal policy tends to be more effective under fixed rates and less effective under floating rates (the opposite of the case with monetary policy). Suppose a government is pursuing restrictive fiscal policies in an attempt to reduce inflationary pressures in the domestic economy. It reduces spending, thereby lowering the demand for money and causing interest rates to decline. Capital flows out of the country, putting downward pressure on the exchange rate. To resist this pressure the central bank, under fixed exchange rate rules, buys the domestic currency (sells foreign exchange.) This reduces bank reserves (they pay the central bank in cash for the foreign exchange they are buying). The banking system consequently restricts credit, a move which supports the government’s efforts to lower aggregate demand in the economy. Under flexible exchange rates, the central bank would not have to intervene to maintain the value of the domestic currency which would simply be allowed to depreciate. This, however, would cause the demand for exports to rise and for imports to fall. The resulting rise in the value of net exports stimulates the domestic economy, offsetting the effect of the contractionary fiscal policy. While the considerations just outlined are relevant to the debate over the relative merits of fixed versus flexible exchange rates, they also serve to illustrate how complex macro-economic policies are and how uncertain their outcomes may be in particular circumstances. Some economists, notably the monetarists and their present day counterparts, believe that such policy efforts may be futile at best and counterproductive at worst. The best policy in their view would be no policy at all, or at least no discretionary policy, leaving the door open to some systematic, perhaps rules-based interventions to smooth out the adjustments made by the "natural" interaction of market forces. Again, as would be expected from what has gone before, those who favour an active, discretionary form of macroeconomic intervention in the economy argue that such "natural" market forces are as likely to be destabilising as stabilising and that there is ample evidence that governments can learn to apply macroeconomic policies to achieve objectives which are widely agreed to be desirable. Perhaps ironically, the countries most often cited as examples of the successful application of macroeconomic policy are countries like Germany which have conducted relatively conservative, non-expansionary, restrictive policies. Whether their success has been due to these policies or whether the policies have been appropriate because of the very favourable real economic situation such countries were in remains a matter of some disagreement. Neo-Conservative Thought and Practice The "back to the free market" movement of the neo-conservative governments which held power in Britain under Margaret Thatcher, in the US under Ronald Regan and George Bush, and similar regimes in several other countries in the 1970s and 1980s, provided fertile ground for experimenting with the kinds of conservative economic policies recommended by Friedman and his followers. The results of such experience are still in need of study, but the impression to date is that they were as ineffectual and, in many instances, counterproductive of desirable results as the earlier attempts by governments influenced by the neo-classical consensus of Samuelson had been to "fine tune" the economies of their time. Alarming increases in income disparities, two recessions, one in the early 1980s, the other in the early 1990s, which were the most severe since the Great Depression, rampant episodes of commercial excess in the newly "deregulated" security markets, financial instability, persistent unemployment despite drastic cuts in workers’ real wages, a new wave of mergers and take-overs which increased the power of big business, a loss of confidence in future economic prospects for new entrants to the labour market, massive reductions in manufacturing employment as jobs moved overseas to the less developed regions, all appear to be part of the story. Friedman and like-minded theorists could, and did, blame these outcomes on the incompetence of those charged with implementing their policy recommendations and also, perhaps with good reason, on changes in the economic environment which no one could have foreseen, including such things as the sudden collapse of the Soviet Union and its satellite economies in eastern Europe, the subsequent depression in the American "military industrial" complex, the decline of American influence world-wide, the change in the economic status of women, to mention a few. As the century comes to an end, no new body of theory has emerged to explain these developments. One predictable result has been a revival of Keynesian ideas considerably tempered with due regard to monetary influences and "supply side" considerations which had been absent in the earlier Keynesian approach. "Neo-Keynesians" have in fact had some success in rehabilitating the Samuelson synthesis by incorporating the concept of aggregate supply in their models. This makes it easy to explain what in the 1970s had been the great mystery: how inflation could coincide with unemployment. The OPEC-induced energy cost increases of the 1970s coupled with strong union pressure to maintain real wage rates, can be taken to have shifted the aggregate supply function upward, so that even without changes in aggregate demand, macro equilibrium would be established at higher price levels with no increase in employment. Most elementary economics texts now incorporate this in their presentation of what is otherwise still a recognisable Samuelson type of macro model. Other revisions allow for the possibility that the money supply and interest rates may have more of an influence than earlier versions of this type of theory had conceded. At the more advanced levels at which economic theory is studied, however, the field appears to be occupied almost entirely by a neo-classical economic model which harks back to the neo-classicism which was popular at the end of the last century. Because it is invariably cloaked in mathematical notation, it resembles both in content and method the version of marginal neo-classical theory developed by Walras, in particular. The modern expression of this analysis has been greatly influenced by the work of Kenneth Arrow, whose book, co-authored by Frank Hahn, General Competitive Analysis, published in 1971, is one of the principle statements of modern mathematical general equilibrium theory. None of this work is accessible to the non-specialist because of its technical nature. If it were translated into ordinary language, however, anyone familiar with the older neo-classical literature would feel quite at home. Markets are assumed to be perfectly competitive. The distribution of income is given. Everyone is motivated by self-interest and seeks to maximise his or her total satisfaction. Everyone has perfect knowledge of all relevant information needed to make rational decisions. Everyone enters into exchanges with one another, responding to market prices which fluctuate in response to supply and demand conditions, and this trade continues until no one can benefit by making an additional trade. At this point all markets have cleared, there are no surpluses or shortages and all prices are equilibrium prices. Everyone will then have maximised his or her satisfaction and the total satisfaction of the society will be a maximum. As for macro-economic relationships, they are those suggested by the more extreme conservatives of the rational expectations school. The equilibrium rate of unemployment is the natural rate as posited by Friedman. There is no room for discretionary policy. Imagine this being expressed in a series of equations, axioms and conditions and you have some idea of what modern general equilibrium theory comprises. Those who have pioneered this modern restatement of neo-classical theory (and this is certainly true of Arrow, who has never become associated with policy issues) seem to have little in the way of a positive ideological orientation, but by building theoretical systems which are on the basis of their assumptions perfect in their automatic functioning, they have produced a body of theory which, if it yields any policy inferences at all, has nothing to do with reality unless that reality resembles in some significant degree the perfectly competitive self-regulating market economy dreamed of by Adam Smith. Thus, many of the leading economic theorists today appear to have little to say about contemporary economic problems. As Joan Robinson once remarked concerning the policy recommendations of laissez-faire economics, if the system is assumed to work perfectly, there is little to say about how to fix it. If these mathematical models do provide a useful basis for understanding the real world and if, as the rational expectations school claims, people base their behaviour on all the information available, then economic theory (presumably their economic theory) feeds back into the real world. People behave as economic theory suggests they should. In this way the real world comes to resemble the model. Take the illusion of unemployment, for example. Unemployment cannot persist in the model because real wages must fall if unemployment really exists and employers will therefore find that to maximise their profits they have to hire more labour. Unemployment disappears. If an observer thinks he or she observes persisting unemployment, the observer is mistaken. What is being observed are people engaged in rational search behaviour which, given their preferences and prevailing labour market conditions, results in them being without employment. But this is not the same as being unemployed, any more than a person who chooses to retire from the labour force would be considered to be "unemployed". Do these mathematical neo-classical models imply that nothing ever changes once equilibrium is attained? This idea of a "stationary state" was a feature of the old classical models developed by Ricardo and others in the early 19th century. They imagined that, as capital accumulated and output increased, profits would fall, the incentive for further investment would disappear and growth would cease. In the modern re-statements, growth continues along a "growth path" determined by the rate of saving, the rate of net investment, and the interest rate. All these rates are expected to move in harmony with one another. If they do not, there are temporary periods of adjustment, episodic recessions or booms, until they automatically reconvert around the economy’s inherent growth path. Again, the inference is that there is no need for governments to intervene; if they do, they interfere with the "natural" adjustment process and, more likely than not, delay the return to normal growth. If there is any room
for government in this picture, its task is to eliminate obstacles to the
free functioning of markets. Obviously, any regulations which attempt to
fix prices, such as minimum wage laws or rent controls, should be removed
because they distort prices. Taxes have a similar effect and so should
be minimised, which means minimising government spending. Income transfers
from the rich to the poor change the natural system of rewards and incentives
and should be abolished. Productive investment is the chief source of growth
and should not be discouraged by restrictions on profits. It is not difficult
to continue the list until what we have is not so much an implied case
for a somewhat limited role for government in economic life, but the kind
of extreme laissez-faire individualism which had some popularity among
the rich in the 1890s or which today is advocated by the neo-Austrian right-wing
libertarian fringe.
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