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“The Economic Way of Thinking”12th Edition

Chapter 15: Economic Performance and Real-world Politics

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Chapter Outline The Great Depression What Happens in a Recession? A Cluster of Errors Monetary Mismanagement, Monetary Miscalc

ulation Monetary Equilibrium When is Monetary Policy Effective?

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Chapter Outline The Case for Fiscal Policy The Necessity of Good Timing The government Budget as a Policy Tool The Horizons and the Sequence of Effects Deficits Unlimited Why Not Government at All Levels? Discretion and Rules Who is at the Controls?

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Introduction

What difference does it make whetheer the quantity of money in the hands of the public grows rapidly or slowly?

A comon view An excessive rate of growth in a society’s stock of

money will cause inflation

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Introduction

Questions What constitutes an excessive rate of growth?

Is there such a thing as an insufficient rate of growth?

Does too little growth cause deflation （通货紧缩） , or recession?

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Introduction

Even if we know the appropriate rate to prevent these undesireable outcomes, does anyone have the ability to bring it about?

Are there other (perhaps better) ways to prevent undesirable fluctations in the aggregate level of economic activity?

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The Great Depression

GDP fall: 1930 - 9 % 1931 - 8% 1932 - 14% 1933 - 2%

Since WWII output declined in 2 consecutive years only once:

1974 - 0.6% 1975 - 0.4%

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The Great Depression

In 1939 output reached 1929 level. Per capita after tax income fell by:

30% - 1929 to 1933 7% - 1929 to 1939

Unemployment rate= 19% average in 1930’s Unemployment rate= 25% in 1933

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The Great Depression

Marx and Engels (Communist Manifesto) Predicted calamity due to epidemic of overprodu

ction （源于生产过剩瘟疫的灾难）

Claimed the epidemic would bring an end to capitalism.

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What Happens in a Recession? Recession – to recede (retreat) Recession

Entail unintended and, thus, disruptive slowdowns The result of frustrated expectations （预期落空） Occurs when, for some reason, the number and d

epth of the disappointments increase without any compensating increase in the quantity and quality of delightful surprises

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What Happens in a Recession? Production – undertaken in anticipation of a d

emand for the product or service

Recessions occur when demand falls short of expectations

When recession occurs, production and employment are reduced.

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A Cluster of Errors （错误的集群） Recessions – accumulated mistakes

A cluster of errors among participants throuthout the economy

Thousands of entrepreneurs misread price signals provided by the market process

Recessions – correction to prior period accumulation of mistakes Production curtailed Workers laid off Capital liquidated at a loss

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A Cluster of Errors

Questions Why would mistakes accumulate in an economic

system? Why wouldn’t overly pessimistic decisions roughly

cancel out overly optimistic decisions? How could so many people be mistaken?

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A Cluster of Errors

Great Depression Worldwide in scope

US – deeper and longer

Great Depression questions: Cause of the cluster of errors Length and severity

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A Cluster of Errors

Authors contend the cause of errors Expansionary monetary policy of 1920’s

Credit expansion Boom to Bust

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A Cluster of Errors

Milton Friedman

(1912-2006)

University of Chicago

Nobel Prize Winner 1976

Murray N. Rothbard

(1926-1995)

University of Nevada

Dean of the Austrian School economics

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A Cluster of Errors

Rothbard’s America’s Great Depression and Friedman’s A Monetary History of the US Chanllenge the popular perspective

That the Great Depression was caused by the collaplw of the self-organizing properties of the market system

Provide arguments and evidence That the cause, and length and severity of the Great De

pression was a consequence of government policy

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Monetary Mismanagement, Monetary Miscalculation Credit expansion fueled by money expansion

lowers interest rates Over-investment Unsustainable boom If savings increase generated - sustainable

Recessionary bust Investment projects revealed as mistakes

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Monetary Mismanagement, Monetary Miscalculation Credit expansion by central bank

Lowers market rate of interest Investors engage in projects previously unprofitabl

e (at higher cost of capital)

The investment bite is bigger than the economy’s chew, so the system chokes

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Monetary Mismanagement, Monetary Miscalculation There is no logic reason why the bust need be lengt

hy and severe The adjustment process, while painful, can be relatively qui

ck

During the Great Depression, this process of adjustment was thwarted by government policies that slowed down the process of adjustment or actually set in motion new disturbances

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Monetary Mismanagement, Monetary Miscalculation

The Great Depression should be viewed Not as an indictment （控诉） of the market econ

omy

But as the major lesson in history on how monetary policy disturb the coordination process in economic life, both through expansion and contraction of the money supply

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Monetary Equilibrium Coordination central to the economic system Although there may be macroeconomic questions, th

ere are in the end only microeconomic answers

What matters is the incentives and information that individuals face That will lead them to successfully coordinate their actions w

ith others in the market Or direct them to activities which result in coordination failur

es

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Monetary Equilibrium The monetary system is at the center of any advanc

ed economy

Money by its nature cannot be “neutral” （中立） because It provides the link to all exchange relationships throughout

the economy

Imbalance of the monetary system Have an impact on the pattern of exchange and production

in an economy

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Monetary Equilibrium

From a monetary equilibrium perspective Goal of monetary policy should be to strive for:

Monetary neutrality by keeping Quantity supplied = quantity demanded

Then Price stability, or stability of the purchasing power of mo

ney No seriously relative price distortions

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When Is Monetary Policy Effective? The dominant opinion among economicsts

Monetary policy might be effective in preventing inflation

But it is largely ineffectively in countering recession

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When Is Monetary Policy Effective? Monetary authorities can increase excess res

erves,but cannot compel banks to extend loans

Larger money stock may not produce increase in spending

Recession can create a confidence crisis

Central Bank efforts may be for naught

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The Case for Fiscal Policy （财政政策） How can the the central bank or some other a

gency of government persuade people to borrow and spend?

One way would be to enhance confidence of households and busines

s decision makers

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The Case for Fiscal Policy

How can the government help stimulate spending at a time when fear and timidity rule? Public policy designed to enhance public confiden

ce Increase spending directly with fiscal policy

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The Case for Fiscal Policy

Fiscal Policy Using government budget to bring about desired l

evels of spending. The Keynesian Revolution

The General Theory of Employment, Interest and Money (1936)

Proposed controlling aggregate demand for fiscal policy to counteract recessions

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The Case for Fiscal Policy

Fiscal Policy options Changing government spending

Changing taxes

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The Case for Fiscal Policy

Questions: Did WWII confirm the power of fiscal policy? How? Why?

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The Necessity of Good Timing Effective fiscal policy requires knowledge

Status of the economy Recognition time lag （认识上的时滞）

Where the economy is headed Diagnostic time lag （诊断上的时滞）

When policy will impact the economy Implementation time lag （实施方面的时滞）

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The Necessity of Good Timing Effective fiscal policy requires knowledge of t

he future, but… Predicting the future changes the future, because

people read the predictions and act accordingly

This is the paradox with which sciences of human behavior must live

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The government Budget as a Policy Tool Congress has little control over the budget

Fiscal Policy requires agreement Congress President

Haste makes for increased risk of mistakes

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The government Budget as a Policy Tool Question

Why not give the President and Council of Economic Advisors the authority to implement fiscal policy?

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Time Horizons and Politics （任期与政治） The time horizons of those who are entrusted

to construct and implement public policy is important for the selection of the economic policies that will in fact be pursued by the government

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Time Horizons and Politics

Changes in Aggregate Demand Affects output and employment before affecting pr

ices

Politically Expansionary policy is preferred over contractiona

ry policy because…

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Time Horizons and Politics Politically

Favor policies yielding benefits on Well organized and well informed interest groups In the short run At the expense of costs borne by unorganized and ill-inf

ormed mass of voters

The standard pattern in democratically governed societies More frequent and severe recessions along with a

rising rate of inflation

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Time Horizons and Politics

Milton Friedman (Nobel Prize winner in 1976) and James Buchanan (Nobel Prize winner in 1986) Both suport “tying the government’s hands” Both argued that rules would outperform discretio

n in generating good economic policy Friedman argued for a monetary rule Buchanan argued for constitutional rules that calle

d for a balanced budget

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Deficits Unlimited （无限赤字） Why do budget deficits persist when there is

a majority support for a balanced budget?

Answer There is no way to reduce the total budget while e

xpanding each individual item in it.

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Why Not Government at All Levels? Why don’t local governments do not produce

chronic （长期的） deficits?

Answer Local governments do not have control over the m

edium of exchange

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Why Not Government at All Levels? Why did national governments not produce s

uch chronic deficits within peacetime before 1970?

Why has it only been within recent years that other industrialized democracies started to make deficits the rule rather than the exception?

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Why Not Government at All Levels? Answer

The demise of the once-strong prejudice against government deficits (i.e., regarded as immoral)

Strong majority convictions influence public policy

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Why Not Government at All Levels?

How did Keynesian economics impact our willingness to accept federal budget

deficits?

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Why Not Government at All Levels?

Keynesian （凯恩斯主义） analysis budgets don’t have to be balanced from year to year they need noly to be balanced over the course of the busines

s cycle, with surpluses in periods of prosperity making up for deficits in periods of recession

Popular belief among economists in 1960s and 1970s Anyone insisting on a balanced government budget just did n

ot understand “modern economics”

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Why Not Government at All Levels? The trouble with the new doctrine

Its effect is to permit perennial （持久的） deficits There is no fiscal period that can be identified with “t

he course of the business cycle” The surplus that is supposed to balance the deficit n

ever has to be balanced, it can always be promised for the next year or the year after

The bias of the democratic political process takes over and makes deficits the rule rather than the exception

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Why Not Government at All Levels? Milton Friedman

Inflation is everywhere and always a monetary phenomenon

We can modify Friedman’s dictum （名言） Hyperinflationa are everywhere and always the co

nsequences of fiscal imbalances

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Discretion and Rules （自行决定和规则） Evidence from US in the 1970s suggest that

The use of discretionary fiscal and monetary policy to stabilize the economy actually increased its instability

But many people still believe that We do posses the knowledge and skills required to achieve

milder recessions and greater price stability through aggregate-demand management

It failed only cecause the right people won’t in charge

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Discretion and Rules However, institutions should be evaluated

Not on the assumption that angels （天使，品行高尚的人） will run them

Rather on the assumption that Government policies wil be controlled by politicians Monetary and especially fiscal policies will be formulated i

n the same political context that produces decisions on import tariffs, highway construction

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Discretion and Rules

An Alternative to Discretionary Fiscal and Monetary Policy

1. Government expenditures without reference to a stabilization goal

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Discretion and Rules

An Alternative to Discretionary Fiscal and Monetary Policy

2. Tax rates set to balance the budget over a normal period

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Discretion and Rules

An Alternative to Discretionary Fiscal and Monetary Policy

3. The Fed should maintain a steady hand on the stock of money, either holding it constant or allowing it to increase by some definite, known, uniform, and moderate rate

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Who Is at the Controls?

Would a balanced budget amendment eliminate deficit spending and help stabilize the economy?

Answer A difficult task

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Who Is at the Controls?

A budget is a prediction Also, it wouldn’t prevent politicians from timin

g and allocating transfer payments, government purchases, or tax-law changes in ways that destabilize the economy but improve the reelection prospects of incumbents

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Who Is at the Controls?

The functioning of the economy, along with the functioning of government and every other social institution, depends finally on Our mutual ability to secure cooperation

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Who Is at the Controls? Some instability seems to be an inherent char

acteristic of a free enterprise system in which Decisions are decentralized No one knows what everyone else is doing or will

do Most transactions occur throuth the medium of mo

ney

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Who Is at the Controls? Big-picture questions:

How smoothly and quickly do prices adjust to changing conditions of demand or supply?

How smoothly and quickly do resources move about in response to the new information that changing prices present?

These kinds of questions are notoriously hard to answer to everyone’s satisfication

Our judgements about what is possible are subtly colored by our visions of what is desirable

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Once Over Lightly

The Great Depression (1930) and changes in economic theory.

Uncertainty Economic collapse – recession Changes in the volume of money Cluster of errors – miscalculations Policy of monetary equilibrium

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Once Over Lightly

Post WWII recessions and government policies.

Federal Funds Rate Fiscal Policy and Monetary Policy Time Lags and Fiscal Policy Economic forecasting and people behavior Political delays cause timing problems

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Once Over Lightly

Policymakers controlled by political processes

Stabilization policies affected by short time horizons

Unanticipated change in rate of growth of demand will affect output and employment before costs and prices

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Once Over Lightly

Political process tends to produce chronic budget deficits

Government contribution to economic stability might be to do “less”

Discretion stabilization policy vs. fixed rules Economic failures in late 1990’s renewed deb

ate over roles of governments and markets