Economic Policy


I. Introduction: Reagan's Economic Policy

When Ronald Reagan took office as president, he promised to cure the country's economic mess by reducing taxes for upper income groups and corporations, cutting social programs, decreasing the regulatory burden on business, and dampening inflation with a tight money policy. Reagan generally had his way with Congress in instituting these changes. The results were not, however, exactly what he and his supporters expected.

To be sure, the regulatory climate for business improved, the economy grew steadily, federal taxes were reduced, and inflation was curbed. Nonetheless, the federal budget deficit grew at a rate that was unprecedented. Inequalities
in income and wealth became more pronounced. Deregulation contributed to problems of safety in many industries, and to huge losses in the savings and loan industry.

Meanwhile, average wages and median family income barely inched upward. The savings rate and business investment declined as well. Investment flowed not to new plants and equipment, but primarily to such unproductive activities as hostile corporate takeovers, leveraged buy-outs, junk bonds, and tax shelters. These developments accelerated the decline of the United States in the world economy.

The story of President Reagan's economic policy and its impact introduces the topics discussed in this chapter. The objective here is to show how economic policies are made and how, once enacted, they affect the operation of the American economy and the well-being of American citizens.


II. Why Government?

Governments in all modern capitalist societies play a substantial role in the management and direction of their economies. No government today would dare leave problems such as recession, depression, a trade imbalance, or
inflation to work themselves out naturally.

Citizens and leaders in Western democracies have learned that the free market economy, left to itself, is subject to periodic collapse, with bouts of inflation and unemployment. Moreover, government must play a role in the economy because its purchases of goods and services are so substantial that it inevitably has an impact on the economy. Given this presence, it would be difficult for any government to deny responsibility for what is happening in its national economy.


III. The Tools of Economic Policy and the Debate About Their Use

Government actions affect the inflation rate, the level of unemployment, and the growth of income and output in the national economy. Government leaders attempt to do this by adjusting their fiscal and monetary policies. The objective of macroeconomic policy is to achieve full employment, steady
growth, and stable prices.

The method used is to adjust the money supply, government spending, and taxes in such a way that total demand--that is, total spending by government, consumers, and business combined--is roughly in line with the productive potential of the economy.

A. Fiscal Policy

Fiscal tools are not easy to use. Decisions about how much government should spend or what level and kinds of taxes ought to be levied are not made simply on the basis of their potential impact on economic stability and growth. Many
other issues come into play. Federal spending, for example, cannot be readily adjusted up or down as economic conditions change. Nor is it easy to adjust tax rates in response to changing economic conditions.

The legislative process is cumbersome and time consuming, with many interests involved, so changes in tax policy cannot be done annually. Moreover, changes in spending and taxing take so long to bring about that there is considerable danger that policies will be inappropriate by the time they filter into the economy.

B. Monetary Policy

Actions by the Federal Reserve Board affect how much money is available to business and individuals in banks, savings and loans, and credit unions. The more money that is available and the lower the interest rates at which money can be borrowed, the higher overall spending is likely to be. If the Fed wants to increase total demand in the economy, it increases the money supply and lowers interest rates. If it wants to slow the economy down, it decreases the money supply and increases interest rates.

The Fed does this in three ways. It can buy or sell federal securities from private brokers and dealers, change the discount rate (the interest rate the Fed charges to member banks), or change how much banks must have on hand to cover outstanding loans (called reserve requirements).

C. The Debate About the Role of Government in the Economy

People may agree that government must play an important role in managing the economy, but they disagree about how it should do it. Debate revolves around four main alternatives: Keynesianism, monetarism, supply side economic policy, and industrial policy.

English economist John Maynard Keynes showed that capitalist economies do not consistently operate at a level that fully employs a nation's workers or keeps its factories operating. The reason is that total demand is rarely high enough.

The solution, he suggested, is for government to fill the gap during slack times by increasing its own spending or cutting taxes so that businesses and consumers might increase spending. When demand is too high, triggering inflation, government should cut spending or increase taxes in order to
decrease consumer spending.

What Keynes failed to appreciate, however, was the political difficulty of slashing government spending once groups, ranging from farmers to military contractors, came to look at federal monies as a right, even when demand was too high and spending needed to be cut. Despite this serious shortcoming,
the Keynesian approach dominated economic policy in the United States and Western Europe for three decades following World War II.

Monetarists such as economist Milton Friedman argue that the key to a healthy economy is the proper management of the supply of money and credit by central banks. The job of a central bank is to set and enforce long-range targets for growth in the money supply that matches the rate of growth in
productivity. Such a policy, monetarists claim, encourages steady growth in
price stability. Monetarists believe that their approach is more consistent with American values than Keynesianism, because it does not depend on an expansive government. Government only needs to set and enforce money targets so that individuals and businesses can operate in a stable economic environment that permits long-range planning and investment, leaving the free market to do the rest.

According to supply side theory, government should help increase the supply of goods and services in the economy by removing barriers to individual investment and entrepreneurship. In particular, supply side economists
advocate substantial reductions in taxes, welfare, and Social Security, and removal of all but the most essential regulations on business. While tax cuts may temporarily unbalance the budget, supply-side economists believe that
government revenues will increase in the long run because of economic growth, bringing the budget into balance.

Industrial policy advocates in the Democratic party argue that broad macroeconomic fiscal and monetary policies are too blunt to help the United States remain competitive in international markets. What is needed, they say, is national strategic planning following the Japanese and European
models. Strategic planning should guide investment to high- technology sectors and away from outmoded industries, manage the painful social dislocations of a reoriented economy, and encourage a vigorous American export trade.


IV. The Making of Economic Policy

A. Structural Factors

American economic policy is influenced by structural factors. Most economists believe that an industrial, corporate, and transnational economy, such as the American economy today, cannot be left to its own devices. The swings of the
business cycle in such an economy are broad and deeply felt, and the failure of a firm or a set of firms affects a broad range of businesses, investors, lenders, and consumers.

Economic policy is also affected by the health of the economy at any particular time. During periods of prosperity, for example, when growth is joined to low rates of inflation, opinion generally favors loosening the grip of the government on the economy and allowing market forces to take over.

Economic policy is also shaped by the political culture of the United States. Though Americans now believe that the government has an important role to play in the management of the economy, they are still attracted to the free market ideal and are hostile to an activist government. The constitutional rules also matter.

Economic policy, like most other policies in the United States, tends to be fairly incoherent, contradictory, and inconsistent when compared to that of other capitalist nations. Divided government, checks and balances, separation
of powers, and federalism have a great deal to do with that situation.

B. Political Factors

Interest groups, particularly those representing business, take a keen interest in economic policy. Although business usually speaks with a single voice on issues involving deregulation and balanced budgets, it is not always united on
what it wants from the government in terms of economic policy. Nor do business interest groups have the field to themselves. Labor, consumer, and public interest groups are also important players in the economic policy game.

Voters and public opinion mainly affect fiscal policy. The public is attuned to overall economic conditions and generally pays attention to what elected leaders are doing to curb inflation and unemployment and to stimulate growth. The general state of the economy is one of the most important
factors in deciding national election outcomes. Some social scientists believe that there is a political business cycle, in which elected leaders stimulate economic growth prior to elections and postpone economic pain until after elections.

Political parties also play a role in economic policymaking. Because each party has its own electoral and financial constituency, composed of groups with identifiable economic interests, the two parties support different economic
policies. Democrats tend to favor economic policies that decrease unemployment and disparities in income; they worry less about inflation.

Republicans, meanwhile, tend to favor policies that control inflation at the expense of higher unemployment and greater inequality. Thus, inequality decreases slightly when Democrats control the presidency and increases slightly when Republicans control it.

C. Governmental Factors

When things go wrong in the economy, Americans usually turn to the president for action. At the center of every modern president's legislative program are proposals for spending, taxing, and regulation that usually have broad macroeconomic effects. Nearly everything that Congress does has
macroeconomic effects as well.

The overall balance of expenditures and receipts is a powerful fiscal instrument, either stimulating or retarding the economy. Taxes levied by Congress shape the incentives for individual and company economic decision making. Laws that regulate, grant subsidies, or supply loan guarantees
influence economic behavior.

The Federal Reserve Board makes monetary policy for the nation. Made up of seven members and a chairperson appointed by the president, this board regulates interest rates and the money supply. The system of separation of powers and checks and balances allows many groups, institutions, and political
actors to get involved in economic policymaking. Policy decisions are the outcome of bargaining and conflict between the president, the Fed, the OMB, the Treasury, regulatory agencies, and Congress.

D. Values and Economic Policy

Debates about economic policy are spirited because the stakes are high. Decisions about spending, taxing, and regulation not only affect each of our material interests but also involve our deepest beliefs about the kind of government and society that we want to have. Arguments over specific
spending programs, for example, inescapably involve conceptions about the proper role of the federal government.

Many who oppose specific spending programs do so because of their concerns about big government. Debates about taxes concern who shall bear the burden and, ultimately, how much inequality we are willing to tolerate. Regulatory policies concern not only technical and scientific issues but also our
confidence in the ability of private markets to solve their own problems.


V. Government Spending

The federal government spends more than $1.4 trillion annually. National defense accounts for about a fifth of all federal government expenditures. Although the defense budget is quite substantial and much higher than that in other developed Western societies, it has shrunk considerably since
1960, when the defense budget accounted for over half of federal outlays.

The steady downward trend in national defense spending was dramatically reversed during the 1980s, when President Ronald Reagan successfully pushed for a military buildup, but resumed its downward course with the end of the Cold War during the early 1990s.

Outlays for human resources, including welfare, health, veterans, education, and job training grew considerably since 1960 as a proportion of total expenditures, and now account for over half of total spending. While relative spending on human resources remained constant, spending for other
programs in this area of federal government responsibility fell substantially.

Outlays for physical resources, including transportation, energy, and the environment, account for slightly more than 10 percent of federal dollars and are about where they were in 1980. Other federal nondefense outlays--which support programs ranging from housing to agriculture, national parks,
science and technology, international affairs, and the administration of justice--now attract about six cents of every federal dollar spent.

A. How Do We Compare?

Some people argue that government spending in America is out of control. Compared to the other modern nations, however, the United States ranks low on total government spending. A much larger proportion of government outlays in the United States goes to national defense and less to human resources
than in comparable nations.


VI. Taxes

A. The Basic Features of the American Tax System

Although the American tax burden has grown heavier over time, it is significantly lighter than that of most other modern capitalist countries. The U.S. tax system is also different from others in the kinds of taxes imposed. States and localities levy taxes in addition to the federal government.

In 1913, the states ratified a constitutional amendment to allow the national government to institute an income tax. In the beginning, this tax applied only to the most wealthy Americans. The American tax system is unique in its
complexity. The U.S. tax code is a thick document, filled with endless exceptions to the rules and special treatment for individuals, companies, and communities.

B. Who Bears the Tax Burden?

To understand the distribution of the tax burden among Americans, it's important to understand the effects of each kind of tax and how much government revenue comes from each.

The personal income tax is progressive, meaning that higher income earners pay a slightly higher percentage of their income in taxes than do low income earners (the actual percentage paid is called the effective tax rate).

Payroll taxes and sales taxes are regressive, meaning that lower-income earners pay a higher percentage of their incomes than do higher-income earners. The effects of the corporate tax are not clear. Although the calculation of the total
distributive effect of all of these taxes is extremely complex, the most widely accepted figures indicate that the U.S. tax system is either moderately progressive or slightly regressive, depending on how one treats the effects of
corporate taxes.

The tax system is less progressive than it used to be because of big increases in payroll taxes and the decline in the share of total government revenues generated by the income tax. According to the nonpartisan Congressional Budget Office (CBO), the richest one percent of income earners in
the United States saw a drop in the effective rate of their federal taxes of six percentage points between 1977 and 1988, while the least well-off 40 percent of the population experienced an increase of about one percentage point.

C. The Politics of Tax Reform

Debate about taxes usually focuses on questions of economic efficiency, justice, and the deficit. Concerns about efficiency take several forms, but the one most frequently voiced concern of conservatives and supply side economists is that a progressive system with high tax rates at the top acts
as a disincentive for the industrious, because it penalizes high incomes and profits.

Americans concerned about the fairness of the tax system point out that the so-called progressive tax system is not really that progressive, and thus unfair. Once all the exemptions, deductions, and special tax breaks are taken into
account, the American tax system is not as progressive as it appears on the surface. Finally, almost everyone is now concerned because tax revenues fall short of governmental outlays.


VII. The Deficit and the National Debt

The federal deficit is the annual shortfall between what the government spends and what it takes in. The government must borrow to cover the shortfall and pay interest to those from whom it borrows. The total of what government owes in the form of Treasury bonds, bills, and notes to American citizens
and institutions, foreign individuals and institutions, and even to itself is the national debt. Interest on the national debt is an important component of annual federal outlays.

A. The Size of the National Debt and the Deficit

The national debt has increased significantly over a relatively short period of time. Most of the national debt prior to the 1980s accumulated during major wars. All of this changed dramatically during the 1980s, however, when the
size of annual deficits, the rate of growth in the national debt, and interest paid on the debt reached historically unprecedented levels.

This rapid growth in the debt occurred for a simple reason: government spending increased, while government revenues lagged because of the 1981 tax cuts, the deep recession of 1981-1982, and the reduction of the top tax rates in 1986. Increased welfare and other domestic spending had little to do with the increase in the national debt.

B. Does the National Debt Matter?

Professional economists disagree about the effects of the deficit and the national debt. To one group, it is the basis of national decline. To another group, it is a trivial problem.

Pessimists point to several key developments. The national debt relative to GNP is rising at a rate that is unprecedented. They warn that government borrowing to finance the debt may crowd out private investment by driving
up interest rates. Much of the debt is funded by borrowing from abroad, which puts much of the American economy in the hands of non-Americans. Finally, pessimists claim that money borrowed by the government is not put to good use, but instead is squandered on activities that are not productive
economically, such as the military, subsidies, bailouts, and failed social programs.

Optimists argue that the threat of the deficit is greatly exaggerated. They claim that the national debt is not as large as it seems because economists measure it incorrectly. For instance, the considerable assets of the country
(buildings, land, equipment, and natural resources) are not currently included in calculations. The national debt, even normally measured, is no higher relative to GNP than it was during the late 1940s and early 1950s.

Optimists find no evidence of crowding out. They say that there is plenty of money around at reasonable interest rates, but individuals and business enterprises don't use it in a productive manner. Eighty percent of the interest paid on the national debt goes to Americans. Finally, government
deficits are useful for spurring economic activity when labor and productive capacity are being used at less than full capacity, which happens to be most of the time.

C. The Politics of Deficit Management

Despite the lack of agreement about the effects of the national debt, there is no doubt that the issue is an important one. Elected leaders have tried to get the deficit under control. In 1985, fiscal conservatives, worried about the growing national debt, successfully pushed for the enactment of the Balanced Budget and Emergency Deficit Control Act (popularly known as Gramm-Rudman).

Gramm-Rudman specified amounts by which the annual deficit would have to be cut each year over a period of six years with the goal of balancing the budget by 1991. Failure to meet annual targets would trigger automatic cuts in federal spending. Because of difficulties in reaching targets, a bill enacted in 1987 postponed a balanced budget until 1992.

The goals of Gramm-Rudman, even as amended, have not been met, of course. The federal budget is nowhere close to being balanced. Nevertheless, some argue, the act has done some good by putting pressure on the president and Congress each year to make decisions about the budget that takes deficit
reduction into account.


VIII. Regulation

A. Why Government Regulates

If the economy were self-regulating, there would be no need for government regulation. But it is not. People generally want the government to do something to fix the problems caused by market failures. In a democracy, politicians must respond to these popular pressures on pain of losing office.
Regulation is the result.

Some scholars believe that regulation is solely the product of democratic politics. Regulation is caused by the political efforts of powerful business firms that turn to government for protection against competitors. According to
this theory, regulation allows firms to restrict output, deny entry to competitors, and maintain above-market prices.

B. Progressive Era Regulation

Between 1900 and World War I, the U.S. government passed laws to regulate some of the activities of powerful new corporations and break up the enormous trusts. Landmark regulatory measures dealt with such problems as monopolies, unstable financial institutions, unwholesome products, and
unsafe working conditions.  Many scholars believe, however, that major corporations were themselves the beneficiaries of many of the regulatory
enactments of the period and that large corporations played a major role in the conception, formulation, and enactment of regulatory legislation.

C. New Deal Regulation

The next wave of regulatory reform occurred during the New Deal. The regulatory innovations of this period aimed squarely at speculative and unsafe practices in the banking and securities industries that contributed to the Great
Depression. Legislation included federal bank inspection, prohibition of speculative investments by banks, federal deposit insurance, enhanced capabilities for the Federal Reserve to coordinate the supply of money and credit, and the creation of the Securities and Exchange Commission to
regulate stock market operations.  Again, the political sources of New Deal regulation were mixed. The principle impetus for the New Deal came from
popular discontent with the status quo and pressure on the government to solve the many problems of the Great Depression. But powerful interest groups were also at work. Important segments of the corporate community were intimately involved in the formulation of reform legislation and benefited greatly from it.

 
D. The New Social Regulation

The new social regulation of the 1970s was different from regulation of the past. Regulation in this period was directed at corporate practices in general rather than the problems of particular industries. Thus, pollution
regulations covered all industries, as did anti- discrimination rules.

Conscious of the degree to which older regulatory agencies were captives of the industries being regulated, reformers convinced elected officials to encourage broad public participation and accountability. The new social regulation
encouraged citizen lawsuits, for instance, by granting automatic standing in regulatory proceedings to interested parties. This was probably the only time in our history when business was almost entirely on the defensive and was unable
to halt the imposition of laws to which it was strongly opposed.

E. Deregulation

By the end of the 1970s, the mood of opinion leaders both inside and outside of government turned against regulation. Many of them blamed excessive regulation for forcing inefficient practices on American companies, thus, hastening the decline of the United States in the world economy. The
deregulatory mood was spurred by a business political offensive that took the form of funding think tanks, journals of opinion, and foundations favorable to the business point of view, as well as supporting the electoral campaigns of
sympathetic candidates.

The change in climate first appeared in the deregulation of the airline, banking, railroad, and trucking industries under President Jimmy Carter. It reached maturity under President Ronald Reagan's program of regulatory relief.

F. The Future of Regulation

The regulatory state is not only here to stay, but is likely to expand in the future. There are a number of reasons for this. First, little permanent deregulation went through during the 1980s. Second, most regulatory policies are supported by the public. Third, deregulation created so many problems that many people have had second thoughts. Deregulation of the savings and loan industry and its subsequent collapse is but the most glaring example.
Finally, new problems are beginning to appear that will likely stimulate public demands for government intervention.


IX. Economic Policy and Democracy

National economic policy is produced by a political process that contains democratic and non-democratic aspects. The ideal of popular sovereignty is served by the general correspondence between what the public wants and what
government does. The general public continues to support spending in most areas of government programs, although many feel that government wastes too much money in some areas. To be sure, Americans are exasperated by the complexity of U.S. tax policy.

There is also a concern for fairness and worry about its overall economic effect. Nonetheless, the message that the American people want low taxes is conveyed quite clearly to elected officials, and they respond, as shown by how low our taxes are when they are compared with those of other modern
capitalist countries. Finally, in terms of regulatory policies, most Americans support the overall outlines of the regulatory state, and many Americans would like to see more regulations.