Eco Policy

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nment economic policy ebcid:com.britannica.oec2.identifier.ArticleIdentifier?tocId=2630

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Introduction

measures by which a government attempts to influence the economy. Thenational budget generally reflects the economic policy of a government,and it is partly through the budget that the government exercises its threeprincipal methods of establishing control: the allocative function, thestabilization function, and the distributive function.

Over time, there have been considerable changes in emphasis on thesedifferent economic functions of the budget. In the 19th century,government finance was primarily concerned with the allocative function.The job of government was to raise revenue as cheaply and efficiently aspossible to perform the limited tasks that it could do better than theprivate sector. As the 20th century began, the distribution functionacquired increased significance. Social welfare benefits becameimportant, and many countries introduced graduated tax systems. In thelater interwar period, and more especially in the 1950s and '60s,stabilization was central, although equity was also a major concern in thedesign of tax systems. In the 1970s and '80s, however, the pendulum swungback. Once more, allocative issues came to the fore, and stabilization anddistribution became less significant in government finance.

The allocative function

The allocative function in budgeting determines on what governmentrevenue will be spent. Because a high proportion of national income is nowdevoted to public expenditure, allocation decisions become moresignificant in political and economic terms. At all times and in all countriesthe calls for expenditure on specific services or activities, or for moregenerous transfer payments, will always exceed the amount that canreasonably be raised in taxation or by borrowing. The debate about how

these scarce resources should be allocated has continued for hundreds ofyears, and, although numerous methods of deciding on priorities haveemerged, it has never been satisfactorily resolved. In practice, mostdemocracies contain a number of different factions that disagree on theproper allocation of resources and indeed the proper level of public sectorinvolvement in the economy; the frequent change of national governmentsis related to the constant search for the right answers.

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Public goods

Economists have sought to provide objective criteria for publicexpenditures through the so-called theory of public goods. It is generallyrecognized that some goods needed by the public cannot be providedthrough the private market. Lighthouses are a classic example. The costsof a lighthouse are such that no one shipowner will want to finance it; on

the other hand, if a lighthouse is provided for one shipowner, it can bemade available to all for no additional cost. Indeed it must be availableto all, since there is no practical means of excluding ships from using thefacility provided by the lighthouse, even if their owners have refused topay for it. The only practical method of providing such services is bycollective action.

If goods are to be provided in this way, rather than through the privatemarket, it is immediately necessary to confront the twin problems ofdeciding how much to provide and who should pay for that provision.

Even if all individuals wanted the service equallyas, perhaps, withlighthousestheir views on the extent of the service would be influencedby the allocation of the costs. Where different households may havedifferent preferences and some may not want the service at allas, forexample, with defense by nuclear weaponsthese difficulties arecompounded. Economists have tried to devise abstract voting schemesthat would reconcile these difficulties, but these appear to have littlepractical application.

Moreover, others would challenge this whole approach to the problem. Itwould be absurd to say that the consumer has a taste for national

defense and that it is the job of the government to satisfy it. The task ofnational leaders is to evolve a defense policy and persuade the public toaccept it. Similarly, conservationists must attempt to awaken the publicto the importance of parks and wildlife. In the context of public policy,the efficient allocation of resources consists not merely of distributingfunds in the pursuit of given objectives but also involves determining theobjectives themselves.

Genuine public goods pose severe problems for the national budget; it isvery difficult to decide how far particular goodsthe arts, national parks,

even defenseshould be supplied, and therefore no formal procedure ofdetermination is likely to evolve. What should be given to each willcontinue to be the subject of intense political debate, with allocationchanging as the government changes.

Merit goods

The concept of merit goods assists governments in deciding which public


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or other goods should be supplied. Merit goods are commodities that thepublic sector provides free or cheaply because the government wishes toencourage their consumption. Goods such as subsidized housing or socialservices, which predominantly help the poor, or health care services,which help the poor and elderly, are generally regarded as havingconsiderable merit and therefore have a strong claim on governmentresources. Other examples include the provision of retraining schemes or

urban regeneration programs.

Cost-benefit analysis

Once decisions have been made on how the limited national budgetshould be divided between different groups of activities, or even beforethis, public authorities need to decide which specific projects should beundertaken. One method that has been used is cost-benefit analysis. Thisattempts to do for government programs what the forces of the

marketplace do for business programs: to measure, and compare in termsof money, the discounted streams of future benefits and future costsassociated with a proposed project. If the ratio of benefits to costs isconsidered satisfactory, the project should be undertaken. Satisfactorymeans, among other things, that the project is superior to any availablepublic or private alternative. Or, if funds are limited, public investmentprojects may be assigned priorities according to their cost-benefit ratios.

One difficulty with cost-benefit analysis is that every government agencyhas an incentive to estimate favourable ratios for its own projects. Itmust, after all, compete with other agencies for funds. No one can be

certain as to the returns to be expected from an irrigation canal or ahighway. Private investors have also been known to exaggerate theirclaims in appealing to stockholders, but they are generally subject tomarket sanctions that encourage them to err on the side of caution.

In addition to the possibility that cost-benefit analysis may be biased bythe preformed views of those commissioning the study, there are other,more fundamental difficulties. Almost all proposals have effects that aredifficult to value in monetary terms. The siting of a new airport bringsproblems of noise and property blight to local people and increases the

risk that civilians may die in an accident. Putting a sensible value onhuman life has been a continuing difficulty for those carrying outcost-benefit analyses, even though every project does in fact affectprobabilities of life and death. These problems are, of course, notconfined to cost-benefit analysis. Additional expenditure on healthservice or on road safety or better housing or heating old people's homesin winter all affect the number of people who die prematurely. Thefailure of cost-benefit analysis to provide answers to the problems ofvaluing life, or the quality of life, is a reflection of the wider problem


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confronting all decisions on public expenditure: the influence ofsubjective judgment.

Public ownership and privatization

Until the mid-1970s the proportion of economic activity controlled by the

government and the share of taxes in national income tended to increasein most countries. Since then, however, challenges to this growth in therole of government have become increasingly influential, and moves toprivatization have been common.

There are several types of privatization. One involves the sale to privateowners of state-owned assets, and this is most correctly calledprivatization. Publicly owned houses may be sold to their occupants.Commodity stockpiles may be reduced or disbanded. Increasingly,however, attention has been turned to the sale of publicly ownedindustries, thus reversing the move to nationalization that occurred,particularly in western Europe, around and after World War II.

Where the privatized industry operates in a competitive environment, nonew problems arise. Singapore has privatized its airline system, forexample, which now competes with a mixture of privately and publiclyowned international airlines. Where privatization occurs but monopolycontinues, however, there are new difficulties. Both Japan and theUnited Kingdom have privatized their telecommunications networks.Although, in certain limited areas of telecommunications, competition ispossibleand has been allowed to develop in both the United States and

Britaintechnical and legal restrictions inhibit competition in manysectors of the industry.

Regulation is necessary, therefore, to restrict the freedom of privatizedmonopolies, or near monopolies, to raise prices and to exploit consumersin other ways. In the United States, which has by far the longest historyof regulating private utilities, such regulation has normally limited therate of return that they earn to what is considered a fair level. Adisadvantage of this is that it may give the industry no greater incentiveto increased efficiency than would exist in public ownership, since higher

costs can be passed directly onto consumers. There have beenexperiments, therefore, with other forms of regulation, which seek tostrike a balance between incentives for better performance and theability to exploit consumers.

A further problem for such regulation is that utilities and similarindustries normally operate in both competitive and monopoly markets.They may be inclined to use their monopoly power in some areas to gainunfair competitive advantages in others. Despite these difficulties, an


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increasingly wide range of industries, ranging from water supply toairports, are now considered candidates for privatization.

Privatization can also mean the dismantling of existing statutoryrestrictions on competition. State activities are often protected by legalprohibitions on competing private enterprise. German railways, forexample, are entirely state-owned, and the law not only preventscompeting railroads but severely restricts coach services and limitscompetitive trucking. The dismantling of such restrictions is seen as onemethod of improving the efficiency of state concerns.

Another demand of privatization is the contracting out of publiclyprovided services. U.S. municipalities have often entrusted activities suchas refuse collection, and in some cases even fire service, to privatecontractors, and European countries are increasingly experimenting withsimilar schemes. These possibilities demonstrate that a service may begovernment-financed but not necessarily provided by the government; ifextended more widely, the concept could yield a different view of the

economic role of the state.

While the objective of privatization is often to increase the efficiency ofgovernment activities, its implementation may also have importanteffects on government revenue. Any savings that result from lower costslead directly to lower tax rates. Where budgeting procedures do notdistinguish between capital and current transactions, the proceeds ofprivatization sales provide a once-and-for-all boost to revenues. Theavailability of this source of funding for state activity has given anartificial attractiveness to privatization, especially in the United

Kingdom. If an industry is sold for the present value of its expectedearnings and if these earnings are the same in public and privateownership, privatization should have no net impact on public finances. Ifit is expected to be more efficient in the private sector, governmentfinance, on balance, gains. If it is sold for less than the maximumrevenue that would be obtainedand this is often the case, eitherbecause of the difficulty of selling assets as large as nationalizedindustries or because the government wishes to secure a wide dispersionof share ownershipthe impact is likely to be negative.

Other forms of government intervention

Government spending is not the only way in which government allocatesresources. Its regional policies will determine whether domestic andoverseas investors build factories in particular places, while its taxationpolicies will determine whether they build them at all. Governmentcompetition and merger policies affect the structure of industry andcommerce, while regulatory activitiessetting the number of hours shops


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may be open or who may buy cigaretteshave profound effects oncommercial activities.

Government also affects allocations by setting the legal andadministrative framework within which the economy functions. It mayspecify minimum wage levels or control the siting of new ventures andthe activities of existing ones. Such activities of government profoundlyaffect the allocation of resources, but they are rarely monitored orsubject to serious control.

The stabilizationfunction

Stabilization of the economy (e.g.,full employment, control of inflation,and an equitable balance of payments) is one of the goals thatgovernments attempt to achieve through manipulation of fiscal andmonetary policies. Fiscal policy relates to taxes and expenditures,monetary policy to financial markets and the supply of credit, money, andother financial assets.

History of stabilization policy

The use of fiscal and monetary policy as a means of stabilizing theeconomy is relatively recent, for the most part a development of theperiod after World War II. During the 19th century the only stabilizationpolicy was that associated with the international gold standard. Underthe gold standard, if a deficit occurred in a country's balance ofpayments, gold tended to flow out of the country. To counteract thisprocess, the monetary authorities would raise interest rates and stiffencredit requirements, causing a fall in prices, income, and employment;this in turn led to a reduction in imports and an expansion of exports,thus improving the balance of payments. If a country had a surplus in itsbalance of payments, gold tended to flow in; this meant that the interestrate fell and the supply of money and credit was increased. As aconsequence, imports were stimulated and exports discouraged so thatthe surplus in the balance of payments tended to disappear. Theadjustment mechanism also included another important element: capital

movements between countries. When interest rates fell in surpluscountries and rose in deficit countries, mobile international financialcapital tended to flow from the former to the latter, contributing to theelimination of deficits and surpluses in the balance of payments. Theworking of this mechanism was partly automatic and partly the result ofdeliberate actions by the monetary authorities in each country.

In this form of stabilization policy, external stability was achieved at thecost of stability in the domestic economy: fluctuations in domestic


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prices, incomes, and employment functioned as the levers for bringingabout equilibrium in the balance of payments. Occasionally governmentsattempted to reduce the impact of this mechanism on the domesticeconomy, particularly on the price level. In particular, governments insome surplus countries took sterilization actions to prevent the goldinflow from increasing the supply of money and credit to the maximumextent. This could be done if the central bank offset its purchases of

foreign exchange and gold with sales of government securities on thedomestic credit market.

A somewhat more ambitious type of stabilization policy emerged in theperiod after World War I. During the late 1920s and early 1930s the needto reduce unemployment acquired more urgency. Previously, theexchange rate, the balance of payments, and occasionally the price levelhad been considered more important than the situation in the labourmarket. During the 1920s unemployment in Great Britain rose to very highlevels (between 20 and 30 percent of the labour force). Consequently,there was much discussion of whether employment could be increased by

actions of the public authorities. At first, the discussion in Great Britaincentred on the feasibility of public works programs as a means of puttingmen to work; there was a growing belief that these programs might alsobe a good means of raising the general level of economic activity throughtheir effect on purchasing power. Some maintained that budget deficitswould also raise the level of economic activity. An active part in thisdiscussion was taken by the economist J.M. Keynes, and also by theLiberal Party, which in 1928 published proposals for governmentintervention entitled Britain's Industrial Future.

The first countries to adopt the new policies were Sweden and Germany.When the Nazi Party took power in Germany in 1933, its rearmamentpolicies helped to reduce unemployment and to stimulate the economy.In Sweden, the new Social Democratic government attempted in moremodest ways to expand the economy and ease unemployment throughincreased government expenditures in 193233. In the United States, avery limited attempt was made by the administration of Pres. HerbertHoover; but Franklin D. Roosevelt made a more aggressive effort withsuch projects as the Works Progress Administration (WPA), which carriedon its payroll an average of more than 2,000,000 workers per year from

1935 to 1941. Unemployment, however, persisted at a high level untilWorld War II, although there was a significant drop from a level of about25 percent in 1933.

Stabilization theory

The new stabilization policy needed a theoretical rationale if it was everto win general acceptance from the leaders of public opinion. The main


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credit for providing this belongs to Keynes. In his General Theory ofEmployment, Interest and Money(193536) he endeavoured to show thata capitalist economy with its decentralized market system does notautomatically generate full employment and stable prices and thatgovernments should pursue deliberate stabilization policies. There hasbeen much controversy among economists over the substance andmeaning of Keynes's theoretical contribution. Essentially, he argued that

high levels of unemployment might persist indefinitely unlessgovernments took monetary and fiscal action. At that time he believedthat fiscal action was likely to be more effective than monetarymeasures. In the deep depression of the 1930s, interest rates had ceasedto exert much influence on the ways in which owners of wealth disposedof their funds; they might choose to hold larger cash balances instead ofspending more money as the traditional theory had suggested. Nor wereinvestors inclined to take advantage of low interest rates if they couldnot find profitable uses for borrowed funds, particularly if their firmswere already suffering from excess capacity. Keynes's pessimistic view ofmonetary policy had a strong influence on economists and governmentsduring and immediately after World War II, with the result that monetarypolicy was not tried very much during the 1940s. It was often forgottenduring the policy discussions of the time that Keynes's views on theefficacy of monetary policy were related to the particular situation of the1930s.

Another influential idea embodied in Keynes's writing was that ofeconomic stagnation. He suggested that in the advanced industrialcountries people tended to save more as their incomes grew larger andthat private consumption tended to be a smaller and smaller part of the

national income. This implied that investment would have to take acontinually larger share of the national income in order to maintain fullemployment. Since he doubted that investment would rise sufficiently todo this, Keynes was rather pessimistic about the possibility of achievingfull employment in the long run. He thus suggested that there might besome permanent tendency to high levels of unemployment. This also hadconsiderable influence on economic policy during the early postwarperiod; it was some time before those in decision-making positionsrealized that inflation, rather than stagnation and unemployment, was tobe the main problem confronting them.

The desirability of pursuing policies to maintain high levels ofemployment was generally accepted in most industrial countries after thewar. In 1944 the British government stated in its White Paper onEmployment Policy that the government accept as one of their primaryaims and responsibilities the maintenance of a high and stable level ofemployment after the war. One of the most influential Britisheconomists at this time was Sir William Beveridge, whose book FullEmployment in a Free Societyhad a strong impact on general thinking.


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Similar ideas were expressed in the United States in the Employment Actof 1946, which stated: The Congress hereby declares that it is thecontinuing policy and responsibility of the Federal Government to . . .promote maximum employment, production and purchasing power. TheEmployment Act was less specific as to policy than the Britishgovernment's White Paper, but it established a council of economicadvisers to assist the president and called upon him to present to every

regular session of Congress a report on the state of the economy. Thepresident was also required to present a program showing ways andmeans of promoting a high level of employment and production. Similarprograms were adopted in other countries. In Sweden in 1944 the SocialDemocrats published a document somewhat similar to the British WhitePaper, and other such declarations were made in Canada and Australia.

Fiscal policy

Fiscal policy attempts to control the actions of individuals and companiesby means of spending and taxation decisions. On the expenditure side, itcan achieve this by spending money in waysfor example, onconstruction projectsthat stimulate other activity, while on thetaxation side it can affect work, investment, or production decisions bychanging tax rates and levels. Fiscal policy thus has two majorcomponents: an overall effect generated by the balance between theresources the government puts into the economy through expendituresand the resources it takes out through taxation, charges, or borrowing;and a microeconomic effect generated by the specific policies it adopts.Both are important in stabilizing the economy.

Overall fiscal policy involves the government in deciding whether itshould spend more than it receives or less. The development ofcountercyclical fiscal policies in the post-World War II period reflectedthe explicit attempt by some governments to protect their populationfrom world recessions by deliberately spending additional money atappropriate times. Experience with countercyclical fiscal policy has beendisappointing; in many cases, the lag between identifying the problemand fiscal response has been too long, with the result that a fiscal boostcoincided with the next boom, while a contraction might coincide with

the next recession. Fiscal policies that were intended to becountercyclical could end up exacerbating the original problems.

Another facet to fiscal policy is a government's attempt to guide thedevelopment of the economy by more specifically targeted policies. Thusmost countries have from time to time attempted to cushion particularareas from the effects of a decline in their dominant industry by regionalpolicies, to affect labour supply and demand by taxation, and to changethe pattern of consumer purchases by changes to indirect taxes. These


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policies sometimes backfire as unforeseen consequences and interactionsoccur.

The simple notion of budget balance, although widespread, can beseriously misleading to one who attempts to decide whether agovernment is being expansionary or contractionary at a particular time.If nothing else were happening, and there were no inflation, no changesin unemployment or exchange rates, and the country were to have aconstant population of all ages, then the government's fiscal position, orstance, might be said to be neutral (neither expansionary norcontractionary) if spending were an exact match of taxation, charges,and profits on public sector activities. (Even in such a case, however, if itwere pursuing specific microeconomic policies, its neutrality might hidesignificant effects on the behaviour of the economy.) This notion has ledmany countries to believe that fiscal position is appropriately measuredby the size of public borrowing, because this measures the differencebetween the amount government spends and the amount it receives.

The recognition that simple budget balance (not accounting for inflation)may not in fact be neutral when other things are changing has led to anumber of suggestions for more sophisticated measures of fiscal position.The full-employment budget surplus suggested by the Council ofEconomic Advisers in the United States, for instance, attempts to adjustthe simple measure of budget deficit or surplus in reaction to the effectsof deviations from a level of unemployment that it regards as normal orfull. The argument for this kind of adjustment is that high levels ofunemployment cause increased benefit payments and reduced taxreceipts that are abnormal, and if the government were to try to

maintain a simple budget balance at times of high employment, thiswould require a large contraction in the other activities it supports. Asimple deficit, then, may be a surplus on a full-employment basis, andgovernment action may be severely contractionary despite positive levelsof borrowing.

Another type of suggested adjustment recognizes that inflation erodesthe real value of public debt. The neutral simple budget balance, it isargued, only requires that the government maintain its real assetposition. If inflation is eroding the real value of existing debt, then the

government may borrow to an adjusted, or revised, level before itsactions actually reduce public assets.

Although it has come to be recognized that a simple budget deficit orsurplus does not adequately reflect a government's fiscal position, nocountry directly employs measures revised for unemployment andinflation in deciding on countercyclical policies. This is partly becausethey are more difficult for politicians to understand and partly because itis genuinely difficult to decide on the precise form they should take.


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Whatever the reason, many countries, even at times of high inflation andunemployment, continue to focus on the simple budget balancemeasures. The United Kingdom, for example, continued in 198081 toattempt to reduce public borrowing during a serious world recession andran an adjusted surplus. This procyclical policy is blamed by many as acause of the high levels of unemployment that subsequently prevailed inthat country.

The heyday of fiscal stabilization policies was, however, the 1950s and'60s. In the 1970s governments became increasingly concerned aboutinflationary pressures, and important disturbances, particularly the oilcrisis, disrupted world economies. Stabilization became a less importantpolicy goal and one that governments were increasingly unable toachieve. Monetarist economic theories acquired increased influence. Theprimary economic issues determining fiscal policies once again becamethe more traditional concerns of allocation and distribution.

Monetary policy

Although the governmental budget is primarily concerned with fiscalpolicy (defining what resources it will raise and what it will spend), thegovernment also has a number of tools that it can use to affect theeconomy through monetary control. By managing its portfolio of debt, itcan affect interest rates, and by deciding on the amount of new moneyinjected into the economy, it can affect the amount of cash in circulationand, therefore, indirectly affect prices and other economic variables. Inrecent years, governments, discouraged by past failures with fiscal

manipulation, have turned to monetarist policies to attempt control ofthe economy.

At its simplest, monetarist theory postulates that in the economy there isa fixed amount of money, which circulates at a given velocity. Thismoney is then available to finance the various transactions carried out inthe economy at the prevailing prices. Under these circumstances,according to the theory, control of the price level can be maintained bycontrolling the amount of available money.

Although a desire to control inflation has been at the heart of the recentrise to prominence of monetary policies in many countries, monetarypolicy can be used to affect a number of different facets of economicbehaviour. In time of unemployment the central bank may stimulateprivate investment expenditure, and possibly also household spending onconsumer goods, by reducing interest rates and taking measures toincrease the supply of credit, liquid assets, and money. The customarytools for doing this are open market operations, the discount rate of thecentral bank, and cash reserve requirements for commercial banks.


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In open market operations the central bank buys governmentsecuritiesbonds and treasury billsfrom the private sector. The effect isto reduce interest rates by bidding up bond prices. The sellers of thegovernment securities obtain cash that they deposit in the banks, thusincreasing the cash reserves of the banks and enabling them to expandcredit to private borrowers; this in turn causes interest rates in theprivate sector to fall and the terms of credit to become easier. In

response, firms are likely to increase their investment expenditures, andhouseholds are likely to spend more on consumer goods.

The second tool of monetary policy, the discount rate of the centralbanks, is often used together with open market operations. This is theinterest rate at which commercial banks can borrow funds from thecentral bank. If the discount rate is reduced, banks become more willingto extend credit to private borrowers because they can obtain fundsthemselves on easier terms. In many countries, changes in the discountrate tend to be followed by similar changes in the interest rates chargedby banks to their borrowers.

The third tool of monetary policy, that of the cash reserve requirements(and, in some countries, certain types of government securities) forcommercial banks, provides that banks must maintain money balances (inthe form of deposits in the central bank) at a certain proportion of theirliabilities. This means that the banks cannot expand their earning assetssuch as government securities and private loans, beyond that point. If thegovernment reduces the reserve requirements, the banks can expandtheir loans further, thus increasing the total volume of creditoutstanding.

Monetary policy, like fiscal policy, may also be used to combatinflationary tendencies by reversing the above measures; the centralbank will then sell government securities (thereby increasing interestrates and reducing the supply of private credit and money), raise thediscount rate, or increase reserve requirements.

Stabilization policy problems

A broad distinction may be made between two types of stabilizationpolicies: discretionary and automatic. Discretionary policies involvedeliberate actions taken by the authorities, such as open marketoperations, changes in discount rates and reserve requirements, andchanges in tax rates or government expenditures. Automatic policies putreliance on built-in stabilizers that function without any deliberateintervention by the authorities. In the monetary field, for example, anincrease in commodity prices tends to reduce the real value of financialassets, and if the government does nothing to offset this by increasing


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the volume of financial assets in the system, private spending will tend todecline. On the fiscal side, the main automatic stabilizer is the relationbetween tax revenues and cyclical changes in the economy. Duringbooms, tax revenues rise and the need for expenditures onunemployment compensation decreases, channeling a larger proportionof the national income into government coffers; these effects areaccentuated if the tax system is progressive because tax revenues rise

more rapidly than money incomes. Provided that the government doesnot raise its expenditures along with the increased revenues, the budgettends to have a braking effect on private expenditure in boom times andan expansionary effect in times of recession.

The problem of time lags

There has been much discussion over the merits of discretionarypolicies as against automatic stabilizers. One advantage of automatic

stabilizers is that the effects occur without the necessity ofgovernment action, which means that there is no delay, or lag,because of political controversies, administrative problems, ordifficulties in determining whether the time has come to act. Thereare three types of lag in economic policy: the recognition lag, thedecision lag, and the effect lag.

The recognition lag is the time it takes for the authorities to discoverthe need to make a change in economic policy. The reasons for thistype of lag are that statistical information is often somewhat behindthe event and that it is sometimes difficult to distinguish betweenrandom fluctuations and fundamental shifts in economic trends.Governments prefer to wait until there is certainty that, say, anincrease in unemployment is not a passing thing.

The decision lag is the period between the time when the need foraction is recognized and the time when action is taken. Although therecognition lag is presumably of about the same duration for bothmonetary and fiscal policies, the decision lag is usually considerablyshorter for monetary policy than for fiscal policy. The central bank canchange monetary policy almost overnight, whereas a change in fiscal

policy is more complex, both politically and administratively. In manycountries changes in income taxes, for example, can be made only atthe beginning of a calendar year; such changes are often complicatedby political discussions in the legislative body.

The effect lag is the amount of time between the time action is takenand an effect is realized. Monetary policy involves longer delays thanfiscal policy; the time between a change in monetary policy and itsultimate effect on private investment may be between one and two


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years.

Some economists argue that the sum of all the lags is so long anduncertain that the best strategy is not to take any action; by the timethe effects occur the economic situation may be radically different.Some countries have tried to shorten the lags in fiscal and monetarypolicy. One way to reduce the recognition lag is to improve theforecasting techniques, for example, by using sophisticatedquestionnaires or computerized econometric models.

In order to reduce the decision lag in fiscal policy, some countrieshave given the authorities power to take limited action without theprior consent of the legislature. In the United Kingdom the governmentintroduced a regulation that allowed it to make immediate changes intax policy. In Belgium and West Germany the governments also havesome discretionary powers to change tax rates without first asking thelegislature. In most countries, however, the legislative bodies havebeen reluctant to give up control of the budget, and increasing

skepticism about the effectiveness of stabilization policy has led to aretreat from frequent small adjustments to fiscal policy.

Attempts to shorten the effect lag of fiscal policy have produced newpolicy tools. Some countries now use systems of taxes or subsidies toinfluence business investment within a relatively short time. Attemptshave also been made to reduce the effect lag in monetary policy.Some countries have tried using various tools of credit rationing ratherthan relying on traditional measures such as open market operations.But the effect lag is still a serious problem for monetary policy.

Conflicts among goals

Perhaps the most serious unsolved problem of stabilization policy isthe multiplicity of goals that policymakers must consider. Everygovernment has aims other than stabilizing the economy. First, it muststay in powera need that is likely to limit the alternatives open tostabilization policy, particularly in periods of prosperity immediatelybefore elections. Second, some monetary and fiscal actions impinge on

particular groups in society, and governments may wish to avoid whatappear to be discriminatory policies. Third, a policy designed toachieve one element of stabilization, such as full employment, mayprevent the achievement of another.

The conflict between full employment and price stability seems toarise in two different sets of circumstances. Often wage increases thatare made in the normal collective bargaining process are greater thanthe increases in labour productivity (or output per man-hour); such


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wage increases tend to increase the cost of production and to forceprices upward. The government is then confronted with a choicebetween two unpleasant alternatives. One is to allow the general pricelevel to rise approximately in proportion to the increase in productioncosts; the other alternative is to try to hold prices down by takingmeasures to restrict aggregate demand, thus making it difficult forfirms to shift their increased costs to the consumer through higher

prices. The latter alternative means increased unemployment. Manygovernments have been confronted with exactly this choice ofalternatives. Wage gains made in collective bargaining have forcedthem to choose between allowing prices to move upward orattempting to hold prices stable at the cost of greater unemployment.

Another reason for the conflict between full employment and pricestability is the tendency of wage increases to accelerate when thelevel of employment rises and the number of job vacancies increases.In other words, as the economy approaches full employment wagestend to rise at an increasing speed. As prices begin to rise, the conflict

between full employment and price stability may be furtherexacerbated by the expectation that they will rise still further; thismay, for example, induce employees and their organizations to pressfor greater wage increases than they otherwise would in order tocompensate for the expected price increases.

Another conflict in policy may arise with respect to the balance ofpayments. When the economy is in a period of boom, there is atendency for imports to increase, and sometimes for exports todecrease as well, with obvious difficulties for the balance of

payments. The crisis may be heightened by short-term capitalmovements if buyers and sellers of foreign exchange expect that theremay be a devaluation of the country's currency. This has caused muchdifficulty for many countries in the period since World War II. InBritain and Denmark, notably, periods of boom have usually beenaccompanied by balance-of-payments problems. When that occurs, thegovernment must sooner or later take restrictive actions that slow theeconomy down and increase unemployment; if speculation in thecurrency is already under way, it may be necessary to pursue therestrictive policy far into the next recession. The problem is

accentuated if there have been substantial price increases during theboom that have reduced the country's ability to compete with othercountries. It is ironic that a temporary improvement in theemployment situation may, if it leads to an accelerated increase in theprice level, serve to create greater unemployment in the future, whenrestrictive actions become necessary for balance-of-payments reasons.

Attempts have been made to eliminate these conflicts of policy. Oneremedy is incomes policy, direct efforts by the government to


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prevent employers and unions from raising prices and wages. Variousmethods have been tried. The most moderate is the so-calledguideposts system, under which the government announces the needfor restraints on wage increases and perhaps also sets targets to guideunions and management; this was attempted in the United States inthe early 1960s. In Sweden, responsibility for limiting wage increaseshas been assigned to labour-management organizations where

bargaining takes place in a centralized fashion. A more interventionistapproach is for the government to enter the bargaining process and tryto persuade unions to limit their wage demands. The government maygo still further and announce a wage freeze, or even a system of wageand price control. In the Netherlands, the courts have occasionallybeen empowered to set wages, but the resulting decisions have oftenbeen uncoordinated with the rest of stabilization policy.

Incomes policies have sometimes succeeded for short periods.Generally, however, public refusal to accept the restraints haseventually led to their collapse. In the United States, the guideposts

broke down during the boom of the mid-1960s, and attempts atincomes policy in Sweden and Britain have not been notable for theirsuccess. Even in the Netherlands later attempts to impose the systemhave failed to limit the rate of wage increase.

The question of governmental competence

Governments have displayed serious deficiencies in their ability tohandle stabilization policy. Political leaders often lack economicinformation and understanding, and their economic advisers find itdifficult to explain the economic situation to them and to apprisethem of the relevant tools. There are also a variety of politicalinhibitions against taking action. One consequence is that what isdesigned to be a countercyclical policy becomes a procyclical one;instead of stabilizing the economy it tends to destabilize it. Thepostwar experience in Britain is held by some to demonstrate thedeficiencies of government in handling monetary and fiscal policy. Intime of boom the government often followed an expansionary course;when a balance-of-payments crisis developed it then took restrictive

actiontoo lateand pushed the economy into deeper recession thanwould otherwise have occurred. On the basis of this experience, someeconomists have argued that a policy that did not attempt to counterthe short-run swings in the economy would have been more successfulin achieving stabilization. They maintain that the authorities shouldconcentrate on letting the volume of money and credit increasesteadily at a rate dictated by the long-term growth trend of theeconomy. Those who hold this view believe that capitalist economies


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are inherently stable, that crises are usually the result of bad policieson the part of the public authorities. Most economists do not sharetheir optimism as to the stability of the economy if left alone; theycontinue to believe that governments must seek better tools for thepurpose of short-run stabilization.

Experience in selected countries

The application of full-employment policies after World War II was mademore difficult by the fact that the postwar situation was radicallydifferent from that of the 1930s, when much of the policy thinking hadbeen done. Most governments and their advisers expected a depressionafter the war, but it never materialized. One explanation is that thereallocation of resources from military to civilian uses proceeded moresmoothly than expected. Another explanation is that the consumers spenta larger part of their disposable income than they had been observed to

do in the 1930s, upsetting some of the statistical projections based onempirical data from those years. A third explanation, which appliesperhaps to the years after 1948, was the Cold War between the UnitedStates and the Soviet Union, which raised defense spending in manycountries.

The period of the late 1940s and early 1950s proved to be characterizedby tendencies to inflation rather than to unemployment. Governmentswere slow to realize this and to shift their emphasis fromemployment-creating policies to anti-inflationary policies. The fact thatgovernments had accepted, to a large extent, the belief that monetary

policy was not very important made it difficult for them to combat thetendencies to inflation. In most countries a passive, even expansionary,monetary policy was in effect; interest rates were kept down and thesupply of money was allowed to grow faster than would have beenconsistent with stable prices. Inflationary tendencies were furtherstimulated by the Korean War and the great increases in raw materialprices that accompanied it.

During the 1950s several important developments influenced theattitudes of governments toward stabilization policy. Most of the

economic controls engendered by the war were removed, particularly ininternational trade and finance. The western European countries were ina period of rapid economic growth. With the removal of direct controlson prices, imports, and building investment, governments began todevelop and refine the tools of monetary and fiscal policy. In mostcountries the passive attitude toward monetary policy disappeared duringthe early 1950s; there was increased interest in more flexible monetarymanagement. Interest also grew in developing a systematic fiscal policythat would offset the cyclical swings in production and employment. The


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most energetic attempts to devise a countercyclical fiscal policy weremade in Britain and Sweden. Other European countries and the UnitedStates placed more reliance on monetary policy.

In the United States, a contributing factor in the revival of monetarypolicy was a theoretical reformulation that took place among monetaryand banking experts. This was the so-called availability theory of credit;it held that monetary policy had its effect on spending not only directlythrough interest rates but also by restricting the general availability ofcredit and liquid funds. It was argued that even rather small changes inthe rate of interest for government securities could have a considerableimpact on the supply of private credit; if the supply diminished, thiswould induce banks and other financial institutions to stiffen their creditstandards and ration credit to their customers; this in turn, it wasargued, would tend to curb investment and thus have a braking effect onthe economy. Similar ideas were at work in other countries, but withmore emphasis on limiting the availability of credit through creditrationing, loan ceilings, control of private bond issues, regulation of

installment credit for the purchase of durable consumer goods, and soon.

Serious attempts have been made to put a countercyclical monetarypolicy into practice in most advanced industrialized countries since themiddle of the 1950s. In some, such as the United States, the emphasis hasbeen, as suggested above, on changes in the interest rate and in thesupply of money and credit; in others, such as France, Italy, and Japan,the emphasis has been on the rationing of credit by the central bank.

Fiscal policy has found less use than monetary policy in efforts to controlcyclical fluctuations in the economy. It has been most favoured inBritain, the Scandinavian countries, and the Netherlands. There arespecific situations in which fiscal measures have been used to stimulatethe economy in other countries, as in Belgium and West Germany duringthe recessions of 1958 and 1962. Another example is the postponement ofcertain military expenditures in the United States as an anti-inflationarymeasure during the boom of the mid-1950s, and, most notably, the taxcuts passed by Congress in 1964 and 1981 as a stimulus to economicexpansion. Several countries have taken restrictive fiscal actions to

overcome balance-of-payments crises, including France and Finland onvarious occasions. During the later 20th century there was an increasingtendency to employ fiscal policies in the short run, partly in order toassist monetary policy in solving cyclical problems.

The distributive function

Virtually everything that a government does has some effect on the


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distribution of income or wealth at the various levels of society.Improvements in health care facilities benefit the sick, the old, and thoseabout to have children. An increase in taxes on tobacco and beer affectsthe poor disproportionately, while an increase in capital taxes similarlyaffects the rich. Even regulatory and legislative activity benefits one groupout of proportion to another. The redistributive consequences of thegovernmental budget can be reflected in a variety of ways; sometimes

they are explicit and sometimes they are cited in the debate that followsthe presentation of a budget. Usually, however, these consequences arehidden, unintended, and imperfectly understood.

Incidence of taxation and expenditure

The incidence of taxes is a subject that has generated much academicdebate. It is usual to distinguish between the legal incidence of a tax andits effective, or final, incidence. The legal incidence is on the person or

company who is legally obliged to pay the tax. Effective, or final,incidence refers to who actually ends up paying the tax; if, for example,the whole of a sales tax can be passed on in higher prices to theconsumer, then consumers bear the final incidence of the tax.

Whether the final incidence of the tax is on those who actually pay itdepends on their market power relative to the people with whom theytrade. A payroll tax, for example, is likely to be reflected in lower wagesif labour is mobile and in plentiful supply, but may be borne, at least inpart, by the employer if there are labour shortages. Similarly, if amanufacturer is facing intense international competition, his ability to

pass on any increase in a sales tax is limited; on the other hand, hisability to do so is much greater if he is the sole supplier of a good.

Arguments for income redistribution

Although governments do affect the distribution of resources in numerousways, this is often a by-product of the other things they are trying to do.It has been long debated whether or not governments should seekexplicitly to redistribute income from the rich to the poor and, if so, to

what extent. More generosity to the poor, whether through higherbenefits or through a more progressive tax system, means a higher taxburden on richer people, with, it is argued, consequent effects on workeffort and on other behaviour. The appropriate degree of redistributionhas been the subject of an extensive literature on optimal taxes, buteconomists generally agree that the final determination must be throughthe political process.

Economists point to a number of arguments favouring explicit as opposed


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to indirect methods of redistribution. The primary argument is that thesewould provide a more efficient means of eradicating severe hardship,suffering, or starvation. Left to itself, the market economy createscasualties among those who lack the skills to participate fully or thosewho have failed to generate sufficient resources to tide them over intoold age. Countries have evolved programs for the prevention of severeneed, although the definition of an acceptable minimum standard of

living is typically more generous in European countries than in, forexample, the United States, and this is reflected in the higher share ofpublic expenditure in those countries. In most countries the definition ofpoverty, as measured by the level to which the state benefit systembrings everyone's income, has moved from being absolute (determinedby the minimum requirement of food, clothing, and shelter) to a morerelative concept, which allows the poor to share in real rises in livingstandards.

The second argument for redistribution is that overall social welfare isthereby increased. An additional dollar makes more difference to the

standard of living of someone earning $100 per week than to that ofsomeone earning $1,000. Even if everyone has income above an agreedminimum level, there is a case for redistribution from the rich to thenot-so-rich. The extent to which this should be pursued depends partly onthe perceived distortions the redistribution would cause and partly onhow much more value the far more numerous not-so-rich can squeeze outof each additional dollar.

Other arguments for redistribution occur where the market fails to allowindividuals to redistribute between periods in their own lives. The classic

example is that people tend to have their periods of highest expenditure(while bringing up children) at the points of minimum income (early inlife). Those families with little or no access to credit markets can do verylittle about this, which has been used as one argument for redistributiontoward those bringing up children. A second argument contends thatchildren convey benefits to society as a whole, so that parents should berewarded for creating a public good. This argument would, of course,have little strength in countries with serious problems of overpopulation.

A final group of arguments also concerns market failure. If particular

areas or occupations have declined and the work force has not adjustedto this decline by moving to other areas or through retraining, then somesubsidy to cushion the recessive effects might be considered appropriate.Most countries redistribute from better-off regions to those that havedeclined, or they allocate funds for specific programs designed to helpparticular groups.

Assar Lindbeck


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MLA Style: "government economic policy." Encyclopdia Britannica.Encyclopdia Britannica Ultimate Reference Suite. Chicago: EncyclopdiaBritannica, 2015.

APA Style: government economic policy. (2015). EncyclopdiaBritannica. Encyclopdia Britannica Ultimate Reference Suite.Chicago: Encyclopdia Britannica.

To cite this page:

John Anderson Kay

Additional Reading

The economic role of the government is analyzed in C.F. BASTABLE, PublicFinance,3rd rev. ed. (1903, reprinted 1917); JAMESM. BUCHANANand MARILYNR.FLOWERS, The Public Finances,5th ed. (1980); RICHARDSTONEand GIOVANNASTONE,

National Income and Expenditure,10th ed. (1977); BENTHANSEN, Fiscal Policyin Seven Countries, 19551965: Belgium, France, Germany, Italy, Sweden,

United Kingdom, United States(1969); CHARLESJ. HITCHand ROLANDN. MCKEAN,The Economics of Defense in the Nuclear Age(1960, reissued 1975); JOHNKENNETHGALBRAITH, The Affluent Society,4th ed. (1984); FRANCISM. BATOR, TheQuestion of Government Spending: Public Needs and Private Wants(1960);LEIFJOHANSEN, Public Economics(1965, reissued 1975; originally published inNorwegian, 1965); ERIKLUNDBERG, Instability and Economic Growth(1968);RONALDL. TEIGEN(ed.), Readings in Money, National Income, andStabilization Policy,4th ed. (1978); C.A.E. GOODHART, Money, Information,

and Uncertainty(1975); JOHNG. GURLEYand EDWARDS. SHAW, Money in a Theoryof Finance(1960, reprinted 1971); VICTORIACHICK, The Theory of MonetaryPolicy,rev. ed. (1977); JOSEPHA. PECHMANand BENJAMINA. OKNER, Who Bears theTax Burden?(1974); and ROBERTH. HAVEMANand JULIUSMARGOLIS(eds.), PublicExpenditure and Policy Analysis,3rd ed. (1983).

Kenyon Edwards PooleJohn F. DueAssar LindbeckCharles Nicholas MorrisEd.

Eco Policy

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