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Introduction
During the decades following World War II, it mostly appeared that the
problems of managing the U.S. economy had been solved.
There were some relatively minor ups and downs in the economy, but
until late 2007 it seemed as if the massive economic failures of the
Great Depression were a thing of the past.
The recession that began in December 2007, however, has shaken
the confidence of citizens and policymakers alike...
 By spring 2009 the gross domestic product of the United States
had dropped by more than 6 percent, unemployment had reached
30-year highs, and both sales and investment had plummeted.
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Introduction—Fading Confidence
The concept that government could manage the economy became
widely accepted in the later stages of the Great Depression and the
post-World War II economic boom...
 John Maynard Keynes and other economists provided the
government with economic tools to manage the economy and an
intellectual justification for using such tools.
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Introduction
Confidence in the government’s ability to manage the economy were
bolstered by the economic improvements in the 1950s, 1960s, and
early 1970s...
 Western nations generally experienced economic growth, low
unemployment, and stable prices
 President Kennedy’s advisers spoke of the government’s ability to
“fine-tune” the economy and manipulate economic outcomes
 President Nixon famously proclaimed that “we are all Keynesians
now.”
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Introduction
Economic policy became more and more a central concern of
government...
 as the Clinton campaign reminded itself during the 1992 election,
“It's the economy, stupid.”
 In others words, focus attention on the economy because that is
the issue that concerns the public.
The success of President Obama’s campaign in 2008 was to no small
degree a referendum on the Bush administration’s economic
policies of large tax cuts and relaxed regulations on the financial
sector (some of which started with Clinton) that resulted in massive
deficits and destructive business practices that wrecked havoc on
the economy.
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The Zero Sum Society Era
Even before the collapse of 2007, the United States was confronting
the problems of a so-called zero sum society...
 In a zero sum society, the gains achieved by one segment of the
society come at the expense of some other segment
 Benefits for the growing sector of Americans who are retired
increasingly burden a shrinking working class
 The need to provide a broader sector of Americans with a high
quality education increases government costs.
 And, the high costs of dealing with that sector of the population
that lacks the education and skills to successfully compete in the
market keeps going up.
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How Does the Government Respond?
The government must first create a set of coherent economic policies
These policies consist of many separate decisions, including...
 spending for public and defense programs
 patterns of taxation
 the cost of money (interest rates)
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Goals of Economic Policy
Economic policy has five fundamental goals...
1. economic growth
2. full employment
3. moderate inflation
4. a positive balance of trade
5. manageable debt
There may be trade-offs among these goals, such as the traditional
trade-off between unemployment and inflation.
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Instruments of Economic Policy
Policy instruments to influence the economy include...
1. fiscal policy--spending
2. monetary policy—costs and supply of money
3. regulations and control
4. public (i.e. government) support for business and agriculture
5. public ownership
6. incentives
7. moral suasion
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I. Fiscal Policy
Keynesian theory: run a budget deficit to stimulate a lagging
economy, and run a surplus to reduce inflation in an “overheated”
economy.
A lagging economy would be one with low growth and high
unemployment.
An overheated economy would be one growing so fast that prices
(inflation) were increasing too fast (scarcity creates inflation).
Keynesian tools have not always been used well
 there has been a tendency to run deficits and not to run
surpluses, i.e., “one-eyed Keynesianism”
 There is also “weaponized Keynesianism” –refusal to cut military
spending
 from 1950 to 2011, there were 56 budget deficits in 61 years
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Fiscal Policy—Estimating revenues and Spending
It is not easy to estimate appropriate levels of revenues and outlays...
 when the economy begins to turn downward, government
revenues decline, as workers become unemployed and cease
paying income and Social Security taxes, and unemployed
workers and their families begin to place demands on a variety of
social programs including unemployment compensation and food
stamps.
 the decline in revenue and the increase in expenditures then
automatically push the budget toward a deficit, without political
leaders’ making any conscious choices about fiscal policy
 unexpected events like 9/11 and Hurricane Katrina also contribute
to the final budget balance
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Fiscal Policy
Economic policy can also reflect partisan ideology which overrides
thoughtful policy.
The Bush tax cuts of 2003 were justified as a supply-side economic
stimulant...
 the federal budget quickly went from a surplus of $127 billion in
2001, to a deficit of over $426 billion in 2005
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Making Fiscal Policy
Presidents generally begin the budget process with the goal of
balancing the budget, but they are soon overwhelmed by the
complexities of the calculations and the political pressures to spend
without taxing.
President Bush II did not ask Congress to pass any new taxes to pay
for the wars in Iraq or Afghanistan, or to cover his Medicare drug
plan (an attempt to close the donut hole).
When asked why he did not have a funding plan for the two wars and
the Medicare changes, Bush argued that his tax cuts would expand
the economy and bring in more revenue. It did not happen.
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Supply-Side Economics—A version of Fiscal Policy
The fundamental idea of “supply-side” economics is to increase the
supply of labor and capital so that economic growth will take place
This basically calls for reducing taxes (especially on top earners and
corporations) and reducing regulations on businesses.
The argument is that the tax reductions will result in increased
investments, growing the economy and therefore expanding the
nation’s tax base.
Taxing a larger economy will bring in more tax dollars even though the
rate of taxation has declined.
Reducing regulations will also allow businesses to thrive.
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◦ By contrast, Keynesian economics argues for providing
people (usually the less affluent) with increased income
through government expenditures, with the expectation
that they will spend the money and create demand for
goods and services.
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Supply-Side Economics
The major instrument of Reagan’s supply-side theory was the
Economic Recovery Tax Act of 1981 (ERTA)...
 over four years, ERTA reduced the average income tax by 23
percent
 the tax cut advantaged those in higher income brackets,
 The argument was that lower taxes would encourage the wealthy
to invest, expanding the economy and the tax base.
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Supply-Side Economics
What was the impact of ERTA?
 There was a massive increase in the federal deficit:

Because federal expenditures were not significantly
reduced.

Because the reduction in tax rates did not substantially
increase revenues
The Reagan administration stuck with supple-side policies as did the
succeeding Bush administrations.
Reagan increased the deficit by 188.6%, Bush by 55.6%, Bush II by
89%.
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Clinton’s Reversal—he raised taxes
By the end of the Clinton administration, large deficits seemed to be
at an end
There was a lot of celebration of the positive benefits...
 less foreign capital would be required to fund debts
 less borrowing from foreign sources would stabilize domestic
interest rates
 the reduced burden of debt repayment would free up money for
other purposes
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Bush II—Back to Supply-Side Economics
But Bush Jr. returned to supple-side economics
Bush convinced Congress to cut taxes (mostly on the rich), lead
America into two unfunded wars, signed off on unfunded
changes in Medicare and further reduced regulation of the
banking and Wall Street sectors.
The result was massive deficits and the economic crisis of 2007, 2008
and 2009.
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II. Monetary Policy
Monetary policy stresses the importance of controlling the money
supply as a way to influencing the economy
In the United States, the Federal Reserve Board (the Fed) and
member Federal Reserve banks are the primary makers of
monetary policy
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Monetary Policy—Buying or selling securities
The Federal Reserve banks principal tools for influencing the
economy are...
1. open market operations...

the most commonly used tool of monetary policy

open market operations involve the Fed entering the
money markets to buy or sell securities issued by the
federal government...
the Fed sells securities to reduce the supply of money
the Fed buys securities to expand the money supply
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Monetary Policy—Altering the discount rate
The Federal Reserve banks also alters the discount rate and the
federal funds rate to influence the economy.

these are the rates of interest at which member banks can
borrow money from the Fed or from each other

rate increases make money more costly to borrow and will
slow down the economy and inflation
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Monetary Policy—Changing the Reserve Requirement
The Federal Reserve banks can also influence the economy by
changing the reserve requirement...

this is a change in the amount of money that member
banks are required to keep in reserve to cover their
outstanding loans (normally around 10 percent)

reducing the reserve requirement makes more money
available for loans and should increase economic activity

this is a more drastic tool, used to effect quick change
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III. Regulations and Control
Antitrust regulation is an important form of economic control...
 the Sherman Act of 1890
1. intended to ensure that a few firms did not control an
industry and then extract excessive profits
2. however, the enforcement of sanctions was problematic
 the Clayton Act of 1914
1. provided clearer, but still ambiguous, definitions of actions
that constituted “combinations in restraint” of trade
2. provided an enforcement mechanism that could act
administratively rather than entirely through the courts
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

Designed to regulate the investment activities
of banks—particularly their use of customer
money (as opposed to their own money) to
finance investments.
Amended in 1999—giving banks a much
wider investment latitude, including their use
of customer funds.
What is Public Policy?
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Regulations and Control
Antitrust regulation has been an important mechanism for fostering
competition, but some doubts have been raised recently.
 the 1990s concern was with external competitiveness and
intellectual property rather than internal competition
 the 1998 prosecution of Microsoft provided a glimpse of the
complexity of the issues involved...
1. Microsoft had created a virtual monopoly, but would the
software market be better served by more competition if
there were problems of compatibility?
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Regulations and Control
By the summer of 2002, some Americans were wishing for a more
regulated economy given numerous identified abuses...
 revelations of malpractice at Enron, WorldCom, and Xerox
 the Securities and Exchange Commission was proving to be
ineffective
Changes in accounting standards and corporate governance have
increased regulation, but some argue for better standards.
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Regulations and Control
The economic “meltdown” of 2007-2009 made it clear to most
Americans that the regulation of banks and the financial markets in
the United States was inadequate
 the banks had been deregulated during the 1990s (by
amendments to the Glass-Steagall Act of 1933) and became
involved in a range of risky investment activities
 further, they and other financial institutions began to provide
“subprime” mortgages to potential homeowners who would not
normally have had sufficient credit to qualify for the loans
 while initially providing lower-income people an opportunity to
own their own home, these loans now are associated with
massive levels of foreclosures that have caused thousands of
people to lose their homes
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IV. Public Support for Business
Governments provide a number of direct subsidies to industry...
 research and development—much of University research
 subsidizing of credit
 provision of economic information and weather information
 access to public facilities
In 2011, according to the CBO, the federal government supplied over
$160 billion in direct and indirect support for business and industry
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Public Support for Business at the State and Local level
State and local governments provide supports to business and
industry in a competitive environment...
 state and local governments attract industry with direct services
(e.g., water and transportation) and tax credits and subsidies
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Public Support for Business
Solving the problems of American industry or promoting them can be
viewed in the context of an “industrial policy debate,” a debate about
whether and how government should assist business and industry.
Should Obama have bailed out the auto industry? Should he have
saved the banks, Wall Street firms, and AIG?
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Public Support for Business
It is often argued that industrial policy should provide
 direct government grants for the modernization and expansion of
industry—e.g., the sustainable energy industry
 trade policies, such as tariffs and barriers, to get industry “back on
its feet”
 Deregulation to reduce the costs for certain businesses
 research and development
 regional policy to redistribute industrial fortunes to failing areas
 Programs like the EITC, SNAP and Medicaid provide assistance
to workers paid low-salaries by businesses, many of which are
huge corporations that make large profits. (California—about $86
million a year to support Walmart employees.)
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V. Government Support for Business
Government has regularly been involved in supporting U.S. industry..
 many of the country’s great industrial ventures, including the
westward extension of the railroads and Hoover dam, were
undertaken with the direct support of government
 some argue that there should be even greater need for
government support for business and industry than in the past,
given the declining industrial position of the United States
 however, too much dependence on government to bail out losers
– banks, Wall Street, the airline industry and, more recently,
automakers – may mean that American industry ceases to be
responsible for its own revitalization and simply waits for the
public sector to rescue it—moral hazard.
 Should we allow banks to be too big to fail?
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VI. Incentives
Government influences economic change by providing incentives for
desired behaviors—renewable energy (cheap coal and $3 gasoline
make alternative energy policy problematic).
The administrative costs of incentive programs are relatively low,
particularly compared with the costs of subsidies that may be
considered as alternatives
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Incentives
Incentives for structural change in the U.S. economy have been...
 the oil depletion allowance and allowances for nonrenewable
resources
 the capital gains provision of tax codes to encourage investment
 tax credit and depreciation schedules to encourage investment
 States and cities provide tax breaks to companies to convince
them to open businesses in their community.
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VII. Moral Suasion
Presidents often attempt to use persuasion...
 Lyndon Johnson appealed to patriotism in asking industries to
restrain price increases
 George H. W. Bush sought to manipulate symbols (by buying
socks in a shopping mall) to persuade Americans to start buying
things again
 George W. Bush argued that the economy was better than his
critics believed and attempted to use this optimism to produce a
more robust economy
 Barack Obama spent the first months of his administration
attempting to buoy consumer confidence to combat the economic
recession
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