Fiscal Policy: Automatic Stabilizers

There is nevertheless one kind of fiscal policy that does work rapidly enough to be important. The so called fiscal automatic stabilizers swing into action within three months to moderate business cycle-driven swings in disposable income and therefore moderate the business cycle.

Whenever the economy goes into a recession or a boom, the government's budget surplus or else deficit begins to swing in the opposite direction. As the economy enters a boom tax collections as well as withholdings automatically rise for the reason that incomes rise. Expenditure on social welfare programs like food stamps falls because higher employment and higher wages mean that fewer people are poor. Therefore the government budget moves toward surplus, without Congress passing or the President signing a single bill. As well as if the economy enters a recession social welfare spending rises, tax collections fall and the government’s budget swings into deficit.

As unemployment increases and national income falls taxes fall by about 30 cents for every dollar fall in national product. Expenditures rises by about 7 cents for every dollar fall in national product. A $1 drop in national product produces only a fall of 70 cents in consumers' disposable income. Therefore, an automatic stabilizer offers more than one dollar's worth of a boost to aggregate demand for each three dollar fall in production.

Such fiscal automatic stabilizers would be large sufficient to reduce the marginal propensity to spend from about 0.6 to about 0.4. This would entail a reduction in the size of the multiplier from about 2.5 to about 1.67 Business cycles could be significantly larger if these automatic stabilizers did not exist, if the Federal Reserve found itself not capable to compensate for their disappearance and if their disappearance didn’t lead to counteracting changes in the marginal propensity to spend.

Rules vs. Authorities:

In the late 1940s Chicago School economist The Henry Simons set the terms for a debate over macroeconomic policy that continues to this day. He asked if macro-economic policy be conducted "automatically," as-per to the rules that would be followed no matter what?  Or must macroeconomic policy be left to authorities--bodies of appointed officials--provided with wide discretion over how to utilize their power and given general guidance as to what goals to pursue?

Competence and Objectives:

The initial reason for automatic rules is that we fear that the people appointed to authorities will be incompetent. If people are appointed for the reason of friendships from the past or because of their ability to rally campaign contributions for a particular cause, there is little reason to consider that they will be skilled judges of the situation or insightful analysts. Better afterward to constrain them by automatic rules. Even if those chosen to authorities are well-intentioned they may well fail to find good solutions to macroeconomic harms. The stream of public discussion about macroeconomics is polluted by a large quantity of misinformation.

A subsequent reason for fixed rules is that authorities might not have the right objectives. To institute a excellent rule it is only necessary for the political process to make the right decision once--at the moment the rule is settled. However an authority making decisions every day may be more likely to start pursuing objectives that conflict with the long-run public interest. The condition of the economy at the moment of the election is a powerful influence on citizens' votes. Therefore politicians in office have a personal power incentive to pursue policies that will sacrifice the health of the economy in the future in order to obtain good reported economic numbers throughout the election year.

The replacement of technocratic authorities--like the Federal Reserve--in the place of Prime Ministers, Presidents and Finance Ministers provides some insulation. It is this panic that politicians will have objectives dissimilar from the long-run public interest that has led various to advocate that monetary policy be made by independent central banks. If stabilization policy is to be prepared by authorities it must be made by authorities placed at least one remove from partisan politics.

Economic Policy: The Political Business Cycle and Richard Nixon

The most famous illustration of the political business cycle at work comes from American politician Richard Nixon's episodic autobiography Six Crises that he published in 1962. Looking back on his beat in the 1960 Presidential election by John F. Kennedy, Nixon inscribed that:

"Two other developments [that] take place before the [Republican Party Convention… [Had] far more effect on the election outcome...

Early in March 1960 Dr. Arthur Burns called on me and he expressed great concern about the way the economy was then acting Burns’ conclusion was that unless some decisive government action were taken as well as taken soon we were heading for another economic dip which would hit its low point in October just prior to the elections. He urged powerfully that everything possible be done to avert this development by loosening up on credit as well as increasing spending for national security. The after that time I saw the President I discussed Burns’ proposals with him in addition to, he in turn place the subject on the agenda for the next cabinet meeting.

The matter was discussed in detail by the Cabinet several of the Administration’s economic experts who attended the meeting didn’t share Burns's bearish prognosis. There was strong emotion against using the spending and credit powers of the Federal Government to affect the economy unless and until conditions clearly indicated a major recession in prospect.

In supporting Burns’ point of view I should admit that I was more sensitive politically than some of the others around the cabinet table. I recognize from bitter experience how in both 1954 and 1958 slumps which strike bottom early in October contributed to substantial Republican losses in the House as well as Senate.

Unluckily Arthur Burns turned out to be a good prophet. The bottom of the 1960 dip did arrive in October. In October the jobless roles enlarged by 452,000. Every television broadcasts, the speeches and precinct work in the world couldn’t counteract that one hard fact.

In 1972 Richard Nixon was President and he had appointed Arthur Burns to be Chair of the Federal Reserve. The year 1972 saw extremely good economic statistics -- at the price of a sharp increase of rate of inflation in subsequent years. Specified the smoking gun provided by Nixon in Six Crises many have diligently searched for evidence that the Federal Reserve made economic policy in 1971 and 1972 not in the public interest but to improved the private political interest of Richard Nixon.

Nevertheless things are more complicated. The Economist Herbert Stein pointed out that Nixon administration economic policy was in fact less expansionary than several Democratic politicians as well as economic advisors wished- the claim that Burns was leaning to the expansionary side of the center of gravity of opinion is merely not correct. And once Arthur Burns had grow to be Chair of the Federal Reserve Nixon administration officials found him to be truly and annoyingly independent.

The verdict is that Richard Nixon exceedingly wished for the Federal Reserve to tune economic policies in a way that would enhance his reelection chances however that the institutional independence of the Federal Reserve worked. White House political pressure in 1971-1972 led to little if any modification in Federal Reserve policy.

Details: Is There in Fact a Political Business Cycle?

Little would dispute that politicians seek to tune the macro-economy to their political advantage. The Bush administration attempted to persuade Federal Reserve Chair Alan Greenspan to pursue a more expansionary monetary policy in 1991 to produce improved economic numbers for the George Bush reelection campaign in 1992 going as far as threatening not to nominate Greenspan for a second term as Federal Reserve Chair. Nevertheless it was unsuccessful. Richard Nixon surely believed when he appointed Arthur Burns to be Fed Chair that Burns would still be the loyal partisan supporter he had been in 1960 -- contemplating this selection Nixon referred to the myth of the autonomous Fed and laughed.

However how successful are governments at manipulating the political business cycle? It isn’t clear. It is right that in the United States since 1948 the fourth year of a President's term -- the Presidential election year -- has seen annual real GDP growth average 0.6% in excess of the average of non-Presidential election years. However there is a fifteen percent probability that at least that large a difference would emerge from random chance and sampling variation alone. Quicker growth in Presidential election years is suggestive but not conclusive.

Furthermore other ways of looking at the data deliver even less evidence. Out of twelve posts 1948 Presidential terms fully six Johnson, Carter, Nixon-Ford, Reagan II, Bush and Clinton I saw sluggish economic growth in the politically-relevant second half of the term than in the first half of the term. This substitute way of looking at the data provides not even a suggestion of evidence one way or another. And it is significant when analyzing any situation not to choose to look only at the data in the way that makes one's preferred conclusion appear the strongest.

There is nevertheless, stronger proof not of a politically-motivated component to the business cycle however of a politics-influenced component to the business cycle. In every seven post-WWII Presidential terms in which Republicans have taken the White House growth in the second year of a Presidential term has been lower than average real GDP growth over that term. By contrast in merely one of the six terms in which Democrats have taken the White House has second-year growth been lower than average.

The odds alongside this pattern happening are astronomical- there is less than one chance in a thousand that it could be the consequence of random sampling variation.

The Economist Alberto Alesina interprets this pattern as viewing that the political parties have or had for Clinton is the Democratic President for whom the pattern of growth fits the Republican model different visions of the relative costs of unemployment and inflation. Republicans have more forbearance for unemployment and less tolerance for inflation than Democrats do. Therefore when Republicans come into office the Federal Reserve feels freer to try to push inflation down to a lower level. For the reason that a considerable portion of inflation expectations relevant for the second year of a Presidential term were formed back prior to the result of the election is known actual inflation in the second year of a term is less than expected inflation and therefore economic growth is relatively low.

The Politically-Influenced Business Cycle:

Legend: Economic growth is likely to be rapid in the second year of the term of a Democratic President. Economic growth is likely to be slow -- or negative -- in the second year of the term of a Republican President.

Economic Policy: Central Bank Independence

A number of economists have examined the relationship between the degree to which central banks are insulated from partisan politics and macroeconomic performance. They have examined the legal as well as institutional framework within which central banks in different countries operate and constructed indexes of the extent to which their central banks are independent.

Alberto Alesina with Lawrence Summers concluded that the more independent a central bank the better its inflation performance. More self-governing central banks presided over lower average inflation and less variable inflation. Furthermore countries with independent central banks didn’t pay any penalty. Countries with independent central banks didn’t have lower real GDP growth, higher unemployment or larger business cycles.

Interpreting this correlation isn’t straightforward. Possibly the factors that lead countries to have independent central banks lead them to have low inflation. Possibly independent central banks do reduce economic growth however only countries likely to have high economic growth for other reasons are likely to have independent central banks. However at least the post-1950 experience of the industrialized countries powerfully suggests that central bank insulation from partisan politics delivers low inflation without any visible macroeconomic cost.

Central Bank Insulation from Politics and Inflation:

Legend: Countries whose central banks are more self-governing have lower average inflation rates.

Source: Alberto Alesina and Lawrence Summers (1993), "Central Bank Independence and Macroeconomic Performance", Journal of Money, Credit and Banking.

Credibility and Commitment:

There is forever a temptation for the central bank to pursue a more expansionary monetary policy: More expansionary policy increases national product and reduces the unemployment rate. Furthermore it has little impact on inflation in the short run in which expectations of inflation is more-or-less fixed. In the short run expansionary monetary policy does forever seem to be a central bank's best option. Suppose firms as well as unions agree on large nominal wage and price increases. Then in the short run it is optimum for the central bank to accommodate inflation and expand the money supply. To fight inflation by increasing interest rates would generate a recession and inflation would continue anyway. Presume instead that firms and unions decide on wage and price restraint. An Expansionary monetary policy is still better inflation will be low as well as the economy will boom.

In whichever case pursuing a more expansionary monetary policy produces a better short-run outcome. Furthermore announcing that monetary policy will be more restrictive produces a better short run outcome as well for by announcing that fighting inflation is job one the central bank may perhaps influence the expectations of managers, workers, investors and households.

Therefore why given the noticeable short run benefits of a more expansionary monetary policy must anyone ever believe that a central bank will aim for low inflation?

Yet in the long run it is definitely the case that a central bank is wiser to keep low inflation as its top priority. Central banks advantage if firms, workers and investors all believe that future inflation will be low. A central bank that surrenders to the temptation to make inflation higher than expected loses its credibility. All will quickly recognize that the central bank's talk is cheap and that it has a strong incentive once expectations pertinent to a period of time are formed to make inflation and money growth higher than expected. Consequently the central bank will find that its words about future policy are ignored in the process of setting expectations and expectations of inflation will be sky-high.

Economists give this disagreement the awkward name of dynamic inconsistency- what it is good to have managers, workers, investors and employers believe that you will do in the future isn’t what seems best to do when the future becomes the present. Several economists have argued that this dynamic inconsistency problem is a strong point on the side of rules rather than authorities- you do not have to worry about a rule breaking its word. Others have indicates that central banks that are concerned with their long-term reputation and credibility appear to have little problem resisting the temptation to make inflation as well as money growth higher than the firms and workers in the economy had expected as well as they have little problem acquiring credibility which they do in several ways including:

•    Argumentative that inflation may be rising.
•    Refusing to admit even the probability that monetary expansion might reduce unemployment.
•    Repetitively declaring that price stability is the primary objective.

The most significant way to acquire credibility is to possess a history of past successful control of inflation.

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