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After 1982, the Fed gradually distanced itself from the proposition that the money supply should grow at a constant rate. Finally, in 1993, then-Chairman Alan Greenspan officially confirmed what many people already knew: that the Fed was no longer using the various Ms to guide policy. He strongly hinted that the Fed was targeting interest rates, especially real interest rates, instead—a hint that has been repeated many times since then. In truth, the Fed had little choice. The demand curve for money behaved so erratically and so unpredictably in the 1980s and 1990s that stabilizing the money stock was probably impossible and certainly undesirable. And at least so far, the Fed has shown little interest in returning to the Ms.

DEBATE: THE SHAPE OF THE AGGREGATE SUPPLY CURVE

Another lively debate over stabilization policy revolves around the shape of the economy’s aggregate supply curve. Many economists think of the aggregate supply curve as quite flat, as in Figure 4(a) on the next page, so that large increases in output can be achieved with little inflation. But other economists envision the supply curve as steep, as shown in Figure 4(b), so that prices respond strongly to changes in output. The differences for public policy are substantial.

If the aggregate supply curve is flat, expansionary fiscal or monetary policy that raises the aggregate demand curve can buy large gains in real GDP at low cost in terms of inflation. In Figure 5(a) on the next page, stimulation of demand pushes the aggregate demand curve outward from D0D0 to D1D1, thereby moving the economy’s equilibrium from point E to point A. The substantial rise in output ($400 billion in the diagram) is accompanied by only a pinch of inflation (1 percent). So the antirecession policy is quite successful.

Conversely, when the supply curve is flat, a restrictive stabilization policy is not a very effective way to bring inflation down. Instead, it serves mainly to reduce real output, as Figure 5(b) shows. Here a leftward shift of the aggregate demand curve from D0D0 to D2D2 moves equilibrium from point E to point B, lowering real GDP by $400 billion but cutting the price level by merely 1 percent. Fighting inflation by contracting aggregate demand is obviously quite costly in this example.

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NOTE: Real GDP in billions of dollars per year.

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3 The reasoning behind the view that the aggregate supply curve is flat in the short run but steep in the long run will be developed in Chapter 16.

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keep the government’s hands off the economy and hence advise adhering to fixed rules. Such political differences are not surprising. But more than ideology propels the debate. We need to understand the economics.

Critics of stabilization policy point to the lags and uncertainties that surround the operation of both fiscal and monetary policies—lags and uncertainties that we have stressed repeatedly in this and earlier chapters. Will the Fed’s actions have the desired effects on the money supply? What will these actions do to interest rates and spending? Can fiscal policy actions be taken promptly? How large is the expenditure multiplier? The list could go on and on.

These skeptics look at this formidable catalog of difficulties, add a dash of skepticism about our ability to forecast the future state of the economy, and worry that stabilization policy may fail. They therefore advise both the fiscal and monetary authorities to pursue a passive policy rather than an active one—adhering to fixed rules that, although incapable of ironing out every bump and wiggle in the economy’s growth path, will at least keep it roughly on track in the long run.

Advocates of active stabilization policies admit that perfection is unattainable. But they are much more optimistic about the prospects for success, and they are much less optimistic about how smoothly the economy would grow in the absence of demand management. They therefore advocate discretionary increases in government spending (or decreases in taxes) and lower interest rates when the economy has a recessionary gap— and the reverse when the economy has an inflationary gap. Such policies, they believe, will help keep the economy closer to its full-employment growth path.

Each side can point to evidence that buttresses its own view. Activists look back with pride at the tax cut of 1964 and the sustained period of economic growth that it ushered in. They also point to the tax cut of 1975 (which was quickly enacted at just about the trough of a severe recession) and the even speedier fiscal stimulus packages enacted after 9/11 and then again in February 2008. Advocates of using discretionary monetary policy extol the Federal Reserve’s switch to “easy money” in 1982, its expert steering of the economy between 1992 and 2000, and its quick responses to the threats to the economy after 9/11 and again after the financial panic in August 2007. Advocates of rules remind us of the government’s refusal to curb what was obviously a situation of runaway demand during the 1966–1968 Vietnam buildup, its overexpansion of the economy in 1972, the monetary overkill that helped bring on the sharp recession of 1981–1982, and the inadequate

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antirecession policies of the early 1990s. Some also argue that the Fed helped fuel the housing “bubble” by holding interest rates too low in 2003–2005.

The historical record of fiscal and monetary policy is far from glorious. Although the authorities have sometimes taken appropriate and timely actions to stabilize the economy, at other times they clearly either took inappropriate steps or did nothing at all. The question of whether the government should adopt passive rules or attempt an activist stabilization policy therefore merits a closer look. As we shall see, the lags in the effects of policy discussed earlier in this chapter play a pivotal role in the debate.

In the presence of long lags, attempts at stabilizing the economy may actually succeed in destabilizing it.

For this reason, some economists argue that we are better off leaving the economy alone and relying on its natural self-corrective forces to cure recessions and inflations. Instead of embarking on periodic programs of monetary and fiscal stimulus or restraint, they advise policy makers to stick to fixed rules that ignore current economic events.

For monetary policy, we have already mentioned the monetarist policy rule: The Fed should keep the money supply growing at a constant rate. For fiscal policy, proponents of rules often recommend that the government resist the temptation to manage aggregate demand actively and rely instead on the economy’s automatic stabilizers, which we discussed in Chapter 11 (see page 225).

DIMENSIONS OF THE RULES-VERSUS-DISCRETION DEBATE

Are the critics right? Should we forget about discretionary policy and put the economy on autopilot—relying on automatic stabilizers and the economy’s natural, self-correcting mechanisms? As usual, the answer depends on many factors.

How Fast Does the Economy’s Self-Correcting

Mechanism Work?

In Chapter 10, we emphasized that the economy has a self-correcting mechanism. If that self-correcting mechanism is fast and efficient, so that recessions and inflations will disappear quickly by themselves, the case for policy intervention is weak. Indeed, if such

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problems typically last only a short time, then lags in discretionary stabilization policy might mean that the medicine has its major effects only after the disease has run its course. In terms of Figure 7, this is a case in which point D comes very close to point A. In fact, a distinct minority of economists used precisely this reasoning to argue against a fiscal stimulus after the September 11, 2001, terrorist attacks and again after the financial panic of 2007–2008.

Although extreme advocates of rules argue that this is indeed what happens, most economists agree that the economy’s self-correcting mechanism is slow and not terribly reliable, even when supplemented by the automatic stabilizers. On this count, then, a point is scored for discretionary policy.

How Long Are the Lags in Stabilization Policy?

We just explained why long and unpredictable lags in monetary and fiscal policy make it hard for stabilization policy to do much good. Short, reliable lags point in just the opposite direction. Thus advocates of fixed rules emphasize the length of lags while proponents of discretion tend to discount them.

Who is right depends on the circumstances. Sometimes policy makers take action promptly, and the economy receives at least some stimulus from expansionary policy within a year after slipping into a recession. The tax reductions and sharp cuts in interest rates that followed both the 9/11 tragedy and the financial crisis of 2007–2008 are the most recent examples. Although far from perfect, the effects of such timely actions were certainly felt soon enough to do some good. But, as we have seen, very slow policy responses may actually prove destabilizing. Because history offers examples of each type, we can draw no general conclusion.

How Accurate Are Economic Forecasts?

One way to compress the policy-making lag dramatically is to forecast economic events accurately. If we could see a recession coming a full year ahead of time (which we certainly cannot do), even a rather sluggish policy response would still be timely. In terms of Figure 7, this would be a case in which the recession is predicted well before point A.

Over the years, economists in universities, government agencies, and private businesses have developed a number of techniques to assist them in predicting what the economy will do. Unfortunately, none of these methods is terribly accurate. To give a rough idea of magnitudes, forecasts of either the inflation rate or the real GDP growth rate for the year ahead typically err by 6 3⁄4 to 1 percentage point. But, in a bad year for forecasters, errors of 2 or 3 percentage points occur.

Is this forecasting record good enough? That depends on how the forecasts are used. It is certainly not good enough to support so-called fine-tuning—that is, attempts to keep the economy always within a hair’s breadth of full employment. But it probably is good enough for policy makers interested in using discretionary stabilization policy to close persistent and sizable gaps between actual and potential GDP.

The Size of Government

One bogus argument that is sometimes heard is that active fiscal policy must inevitably lead to a growing public sector. Because proponents of fixed rules tend also to be opponents of big government, they view this growth as undesirable. Of course, others think that a larger public sector is just what society needs.

This argument, however, is completely beside the point because, as we pointed out in Chapter 11: One’s opinion about the proper size of government should have nothing to do with one’s view on stabilization policy. For example, President George W. Bush is as conservative as they come and, at least rhetorically, he is devoted to shrinking the size of the public sector.4 But his tax-cutting initiatives in 2001–2003 constituted an extremely

4 In fact, the size of the federal government has expanded rapidly during his presidency, in part because of national security concerns, but also because of domestic spending.

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activist fiscal policy to spur economic growth. Furthermore, most stabilization policy these days consists of monetary policy, which neither increases nor decreases the size of government.

Uncertainties Caused by Government Policy

Advocates of rules are on stronger ground when they argue that frequent changes in tax laws, government spending programs, or monetary conditions make it difficult for firms and consumers to formulate and carry out rational plans. They argue that the authorities can provide a more stable environment for the private sector by adhering to fixed rules so that businesses and consumers know exactly what to expect.

No one disputes that a more stable environment is better for private planning. But supporters of discretionary policy emphasize that stability in the economy is more important than stability in the government budget (or in Federal Reserve operations). The whole idea of stabilization policy is to prevent gyrations in the pace of economic activity by causing timely gyrations in the government budget (or in monetary policy). Which atmosphere is better for business, they ask: one in which fiscal and monetary rules keep things peaceful on Capitol Hill and at the Federal Reserve while recessions and inflations wrack the economy, or one in which government changes its policy abruptly on occasion but the economy grows more smoothly? They think the answer is self-evident. The question, of course, is whether stabilization policy can succeed in practice.

A Political Business Cycle?

A final argument put forth by advocates of rules is political rather than economic. Fiscal policy decisions are made by elected politicians: the president and members of Congress. When elections are on the horizon (and for members of the House of Representatives, they always

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are), these politicians may be as concerned with keeping their jobs as with doing what is right for the economy. This situation leaves fiscal policy subject to “political manipulation”— lawmakers may take inappropriate actions to attain short-run political goals. A system of purely automatic stabilization, its proponents argue, would eliminate this peril.

It is certainly possible that politicians could deliberately cause economic instability to help their own reelection. Indeed, some observers of these “political business cycles” have claimed that several American presidents have taken full advantage of the opportunity. Furthermore, even without any insidious intent, politicians may take the wrong actions for perfectly honorable reasons. Decisions in the political arena are never clear-cut, and it certainly is easy to find examples of grievous errors in the history of U.S. fiscal policy.

Taken as a whole, then, the political argument against discretionary fiscal policy seems to have a great deal of merit. But what are we to do about it? It is unrealistic to believe that fiscal decisions could or should be made by a group of objective and nonpartisan technicians. Tax and budget policies require inherently political decisions that, in a democracy, should be made by elected officials.

This fact may seem worrisome in view of the possibilities for political chicanery. But it should not bother us any more (or any less) than similar maneuvering in other areas of policy making. After all, the same problem besets international relations, national defense, formulation and enforcement of the law, and so on. Politicians make all these decisions for us, subject only to sporadic accountability at elections. Is there really any reason why fiscal decisions should be different?

But monetary policy is different. Because Congress was concerned that elected officials focused on the short run would pursue inflationary monetary policies, it long ago gave day-to-day decision-making authority over monetary policy to the unelected technocrats at the Federal Reserve. Politics influences monetary policy only indirectly: The Fed must report to Congress, and the president has the power to appoint Federal Reserve governors whose views are to his liking. For the most part, however, the Fed is apolitical.

A Nobel Prize for the Rules-versus-Discretion Debate

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So where do we come out on the question posed at the start of this chapter? On balance, is it better to pursue the best discretionary policy we can, knowing full well that we will never achieve perfection? Or is it wiser to rely on fixed rules and the automatic stabilizers?

In weighing the pros and cons, your basic view of the economy is crucial. Some economists believe that the economy, if left unmanaged, would generate a series of ups and downs that would be difficult to predict, but that it would correct

each of them by itself in a relatively short time. They conclude that, because of long lags and poor forecasts, our ability to anticipate whether the economy will need stimulus or restraint by the time policy actions have their effects is quite limited. Consequently, they advocate fixed rules.

Other economists liken the economy to a giant glacier with a great deal of inertia. Under this view, if we observe an inflationary or recessionary gap today, it will likely still be there a year or two from now because the self-correcting mechanism works slowly. In such a world, accurate forecasting is not imperative, even if policy lags are long. If we base policy on a forecast of a 4 percent gap between actual and potential GDP a year from now, and the gap turns out to be only 2 percent, we still will have done the right thing despite the inaccurate forecast. So holders of this view of the economy tend to support discretionary policy.

There is certainly no consensus on this issue, either among economists or politicians. After all, the question touches on political ideology as well as economics, and liberals often look to government to solve social problems, whereas conservatives consistently point out that many efforts of government fail despite the best intentions. A prudent view of the matter might be that

The case for active discretionary policy is strong when the economy has a serious deficiency or excess of aggregate demand. However, advocates of fixed rules are right that it is unwise to try to iron out every little wiggle in the growth path of GDP.

But one thing seems certain: The rules-versus-discretion debate is likely to go on for quite some time.

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