Economic policy incrementalism for better fiscal and monetary policy coordination

Economic policy incrementalism for better fiscal and monetary policy coordination

Traditionally, fiscal and monetary policies were made incrementally. In these policy reforms, decision-makers tended to concentrate their attention on modest changes in the extant taxes, expenditures, and fiscal deficits etc, as well as the money supply, inflation, and interest rates. Under this pervasive incrementalism, the U.S. President and Congress would not reconsider the value of all extant programs each year. Neither would the U.S. President and Congress pay much attention to the current levels of fiscal expenditures. The previous year’s budgets would serve as a base of government expenditure for each program. Attractive consideration of the budget proposals focused on new items (i.e. incremental increases) over the previous year’s base. In this view, the U.S. President and Congress would only evaluate incremental changes in fiscal budgets and expenditures, as well as incremental changes in the baseline expectations of economic output growth, inflation, and interest rates etc. In response to the Global Financial Crisis of 2008-2009 and recent rampant corona virus crisis of 2020-2022, U.S. policymakers began to search for new complete fiscal and monetary policies to cause dramatic reforms in fiscal budgets, expenditures, inflation and interest rates, and large-scale asset purchases to avoid a severe domestic recession.

 

The U.S. federal government has complete authority over fiscal policies (i.e. decisions about taxes, budgets, expenditures, and fiscal deficits), as well as monetary policies or decisions about the money supply and interest rates. Fiscal policy involves the annual preparation of the federal budget by the U.S. President and the Office of Management and Budget (which serves as the largest office of the White House). Congress then considers the annual fiscal budget with appropriation bills and revisions of the tax laws. These decisions determine the federal budgets and expenditures, as well as spending priorities among federal programs. Together with tax policy decisions, the fiscal budgets and expenditures then determine the size of the federal government’s annual fiscal deficits or surpluses. Further, monetary policy is the principal responsibility of the powerful and independent Federal Reserve System. The Federal Reserve System expands or contracts the money supply, and thus inflation, through interest rate changes, large-scale asset purchases, and the ongoing supervisory oversight of interbank loan and payment settlements. The Federal Reserve System seeks to achieve the dual mandate of full employment and price stability through low and stable inflation rates. In addition to this dual mandate, the Federal Reserve System often has to maintain financial system stability with stable and reasonable asset market valuation.

 

The main goals of economic policy incrementalism include steady growth in economic output (total GDP and GDP per capita) with higher living standards, full and productive employment of the work force across the country, low and stable money supply and inflation, and financial system stability with reasonably high asset market valuation. A variety of economic theories share and so compete for preeminence as ways of achieving these main goals of economic policy incrementalism. From time to time, economic policy incrementalism reflects different economic theories. Or worse, this incrementalism may reflect the gradual accumulation of relevant but contradictory economic theories and considerations simultaneously.

 

Classical economic theory

Classical economists generally view a free market economy as a self-corrective mechanism. In equilibrium, this free market economy achieves full employment, maximum productivity, and low and stable inflation if the government leaves alone most market participants. In the steady state, the price mechanism adjusts the economic decisions of millions of Americans to bring into balance the supply and demand of goods and services. In each recession, the supply for workers exceeds the demand to cause temporary unemployment, real pay often tends to decline as the price of labor in response to unemployment. Eventually it becomes profitable again for businesses to employ more workers at lower real wages. This profitability helps reduce unemployment as the macro economy recovers from each recession. Similarly, if the demand for goods (cars, houses, clothes, and so forth) declines in due course, many business inventories rise and hence business people reduce prices (often through sales and rebates etc) until demand picks up again. With regard to inflation, general increases in prices usually reduce demand and bring this demand back into better alignment with supply unless the government interferes with the market economy. In summary, classical economic theory relies on the free adjustment of prices in response to incremental changes in demand and supply for the market economy to counter both inflation and output retracement.

 

Keynesian economic theory

According to the U.K. economist John Maynard Keynes, the Great Depression of the 1930s was a natural product of boom-bust fluctuations in demand. Both unemployment and lower real pay reduced the demand for goods and services. Key businesses cut products and laid off workers to adjust for lower demand for their goods and services. From a macro viewpoint, this mass unemployment accelerated the downward spiral. Keynesian economic theory thus suggests that the free market economy might fall into a severe recession with no immediate resolution. Only the government would be able to take the necessary countercyclical steps to expand demand by spending more money itself with lower taxes. The government might not be able to boost demand if the government balances the budget with no additional fiscal expenditures. During a deep recession, the government might need to incur fiscal deficits to add to total demand. In this rare but reasonable episode of the macro cycle, the government would need to spend much more than its fiscal intake of tax revenue. Fiscal deficits and total national debt would grow during recessions. Government debt issuance would make up the fiscal deficits (the discrepancies between lower tax revenues and higher fiscal expenditures). To counter inflationary trends, the government would take the opposite countercyclical steps to influence incremental changes in total demand. For this purpose, the government would most likely counter most macro cycles through strategic engagement in countercyclical fiscal policies.

 

Supply-side economic theory

Supply-side economists contend that it is more important for the government to pay attention to longer-term economic growth (rather than short-term manipulation of aggregate demand). Economic growth requires an expansion in the productive capacity of society. So economic growth increases the overall supply of goods and services with both lower prices and greater product quality improvements. From this fundamental viewpoint, economic growth improves everyone’s living standards with the availability of more goods and services at low and stable prices. Economic growth even increases government tax revenues over the long run.

 

Most supply-side economists believe that the free market economy brings about lower prices and better goods and services. The government is often the problem of, not the solution to, free market capitalism. Government intervention manifests in the form of taxes, expenditures, monetary policy decisions such as interest rate hikes and large-scale asset purchases etc. Higher taxes often penalize hard work, creativity, investment, and so forth. The government should provide tax incentives to encourage private investment. Also, the government should reduce tax rates to encourage work and enterprise. Overall government expenditures should be held in check. The government should minimize financial regulations to increase growth and productivity. In essence, the government should act to stimulate production and supply rather than demand and consumption.

 

Measures of the actual performance of the American economy include the gross domestic product (GDP), the unemployment rate, and the inflation rate. The GDP is the country’s total production of goods and services for a single year in terms of long prevalent market prices. The unemployment rate fluctuates with the real business cycle and so often reflects severe recessions and recoveries. Generally, unemployment often lags behind economic growth of total GDP or GDP per capita. Specifically, the unemployment rate decreases only after the recovery has begun. After years of economic growth in the 1990s, the U.S. unemployment rate fell to near record lows below 5% per annum. With the Global Financial Crisis of 2008-2009, U.S. unemployment rose again. These boom-bust fluctuations of U.S. unemployment seemed to repeat during the recent rampant corona virus crisis from 2020 to 2022. Inflation erodes the value of the dollar as higher prices mean that the same dollars can now purchase fewer goods and services. Hence, inflation erodes the value of wealth plus income, reduces the incentives for households to save, and hurts people who live on pension income (in the common form of annuities). When banks and investors anticipate inflation, they raise interest rates on loans in order to cover the lower value of repayment dollars. In turn, higher interest rates make it more difficult for new businesses to borrow money, for home buyers to acquire mortgages, and for consumers to make purchases on credit. Persistently high inflation and interest rates often slow economic growth.

 

The U.S. mortgage crisis led to the non-incremental Dodd-Frank Act.

In 2008-2009, the U.S. subprime mortgage credit crunch ballooned into Wall Street’s biggest financial crisis since the Great Depression of the 1930s. In September 2008, President Bush sent Secretary of Treasury Henry Paulson and Federal Reserve Chairman Ben Bernanke to Congress to plead for a massive $700 billion bailout of banks, insurers, and investment firms that held illiquid mortgage assets. These senior bureaucrats argued that their proposal was essential to safeguard the U.S. financial system. A full-blown depression might result if the federal government failed to purchase these illiquid mortgage assets. In response, both the Senate and House of Representatives approved the Emergency Economic Stabilization Act of 2008. President Bush promptly signed this bill into law. This non-incremental financial policy reform served as a fundamental response to the unfortunate failures of Bear Stearns and Lehman Brothers (in addition to American International Group and Citigroup in financial distress).

 

The Treasury Department was given substantial power to bail out U.S. financial institutions. Secretary Paulson originally proposed to use the $700 billion appropriation by Congress to buy up toxic mortgage assets with sharp devaluation. Paulson reversed course and decided to use the TARP money to inject cash directly into banks by purchasing shares of their stock. Citigroup was the first in line, and the other major banks (Bank of America, JPMorgan Chase, and Wells Fargo) and investment firms (Goldman Sachs and Morgan Stanley) followed suit. Many critics of the fire sale program argued that by accepting ownership shares in the major banks and investment houses, the government tilted toward financial socialism. Government ownership of the financial industry would have been unthinkable before the crisis. As a result, the Global Financial Crisis of 2008-2009 inspired a non-incremental financial policy reform: the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This legislation built the 5 major pillars of the U.S. financial safety net: capital adequacy rules, leverage limits, liquidity rules, macroprudential stress tests, and deposit insurance rules. Under Dodd-Frank, each U.S. financial institution would be subject to stringent capital and liquidity requirements. Simple leverage limits would help banks and other non-bank financial institutions safeguard against large losses that might arise in rare times of financial stress. Macroprudential stress tests would assess each U.S. financial institution’s medium-term resilience in response to rare but reasonable macro scenarios such as U.S. unemployment above 10% per year and interest rate hikes from the zero lower bound. Further, deposit insurance rules would protect bank deposits below the $250,000 dollar threshold. In effect, this deposit protection would help reduce moral hazard in association with the highly risky bank activities. At the same time, this deposit protection would help shore up taxpayer confidence with no bank runs.

 

Under President Obama’s new Treasury Secretary Timothy Geithner, TARP banks had the obligation to adopt mortgage loan modification procedures to prevent foreclosures. This loan modification program provided financial assistance to mortgage lenders as an incentive for them to modify home mortgages that were in danger of default. The intention was to help as many as 5 million mortgage borrowers refinance their loans at lower interest rates.

 

In addition to the TARP bank bailouts, the Federal Reserve Board made a dramatic decision to pump over $1.5 trillion into the U.S. financial system to unlock residential mortgage, credit card, auto, small business, and student loans. Later, the Federal Reserve System reduced its discount rate to the zero lower bound, to encourage banks to make loans. When the U.S. recession deepened in early-2009, the President and Congress sought to provide additional economic stimulus.

 

American Recovery and Reinvestment Act of 2009

A massive economic stimulus plan, the American Recovery and Reinvestment Act of 2009, was the centerpiece of President Barack Obama’s early policy agenda. Its rare and unique combination of both spending increases and tax cuts totaled $757 billion and turned out to be the largest single fiscal policy measure in American history. This stimulus legislation was written in record time by a Democrat-led Congress. House Republicans were unanimous in opposition, and only 3 Republican senators supported this stimulus legislation. In Congress, Democrats used this program to increase fiscal expenditures in a wide variety of domestic workstreams such as Medicaid, education, unemployment compensation, public health care tech advances, food stamps, child tax credits, disability payments, higher education grants, renewable energy subsidies, and transit transportation subsidies. Republicans complained that much of the spending spree had little to do with stimulating the economy from the Global Financial Crisis. These Republicans further voiced their concern that many spending plans increased government involvement in Democrat-led domestic policy areas. Republicans had traditionally relied on tax cuts to stimulate the economy due to supply-side considerations.

 

The American Recovery and Reinvestment Act included some version of President Obama’s campaign promise of middle-class tax cuts. These tax cuts were one-off payments of $400 to U.S. residents with income under $75,000, and one-off payments of $800 to couples with income under $150,000. These one-off tax incentives were made to anyone who paid social security taxes. Because it was not necessary for the one-off tax recipients to have paid any income taxes, many critics labeled these one-off tax cuts as welfare checks.

 

Federal Reserve System and monetary policy

In the vast majority of OECD countries, central banks have the core responsibility to regulate the money supply, both currency in circulation and bank deposits. Most of the democracies have found it best to remove this core responsibility from the direct control of politicians. Key politicians would face the temptation to inflate the money supply in order to fund new fiscal deficits and expenditures with new money creation instead of new taxation. The end result would be a general rise in prices and a pervasive reduction in goods and services available to private firms and households (i.e. higher inflation).

 

In America, the Federal Reserve System regulates the money supply to avoid both inflation and economic output retracement. The Federal Reserve System oversees and coordinates the ongoing operation of the 12 Federal Reserve Banks, which issue the U.S. greenback in the form of Federal Reserve Notes. These 12 Federal Reserve Banks serve as the regional central banks for both commercial and investment banks. Federal Reserve Banks hold the deposits, or reserves, of banks; lend money to banks at discount rates; buy and sell Treasury government bonds; and assure regulatory compliance by both commercial and investment banks. The Federal Reserve System determines the minimum regulatory requirements for bank reserves and then otherwise monitors the financial health of the U.S. banking industry. The Federal Reserve System plays an important role in clearing inter-bank payments and checks throughout the U.S. banking system.

 

Banks create money in the common form of demand deposits when these banks make loans. Cash currency in circulation and demand deposits constitute the U.S. money supply (or M1). Demand deposits far exceed currency, and only about 5% of the money supply is in the form of currency. Hence, banks determine the money supply in their creation of demand deposits. The Federal Reserve System requires that each bank maintains deposit reserves with some Federal Reserve Bank. If the Federal Reserve System decides that there is too much money in the economy (i.e. some increase in money supply leads to inflation), the Federal Reserve System can raise the requirement for bank reserves to reduce what banks create in demand deposits. In addition to interest rate adjustments, the Federal Reserve System can alter the bank reserve ratio to cause changes in the U.S. money supply (M2 currency in circulation plus bank demand deposits).

 

The Federal Reserve System further causes changes in the U.S. money supply by altering the federal funds rate (i.e. the Federal Reserve System charges private member banks this interest rate for them to borrow against deposit reserves). Each bank can expand its demand deposits by borrowing reserves from the Federal Reserve System at some discount rate. By raising the discount rate, the federal funds rate, the Federal Reserve System can discourage banks from borrowing reserves to contract the U.S. money supply. Interest rates generally (on loans to businesses, mortgages, car loans, and so forth) rise and fall with rises and falls in this discount rate. Interest rate hikes help dampen inflation when price instability starts to threaten the economy. Interest rate reductions can help encourage economic expansion as this dovish monetary policy stance boosts the money supply.

 

The Federal Reserve System further carries out open market operations to trade Treasury government bonds and notes. In the Federal Reserve System, the bank reserves consist of Treasury government bonds and notes. If the Federal Reserve System sells more Treasury bonds and notes, the reduction in reserves limits the Federal Reserve System’s capacity to lend reserves to private member banks. This Treasury asset sale contracts the U.S. money supply. If the Federal Reserve System buys more Treasury bonds and notes, the increase in reserves adds to the Federal Reserve System’s capacity to lend reserves to private banks. In turn, this Treasury asset purchase expands the U.S. money supply. The ebbs and flows of open market operations empower the Federal Reserve System to cause changes in the interest rate to drive incremental changes in the U.S. money supply for a better balance in economic growth, inflation, employment, and capital investment accumulation etc.

 

In the prior recessions, the Federal Reserve Board monetary policy decisions successfully applied interest rate cuts to ease credit in each economic recovery. In the severe recession of 2008-2009, however, the Federal Reserve interest rate reductions appeared insufficient by themselves in stimulating the economy. The Federal Reserve Board reduced the discount rate to the zero lower bound. Further, the Federal Reserve System introduced quantitative-easing (QE) large-scale asset purchases to boost bank credit and the money supply. These large-scale asset purchases involved the Federal Reserve System using the Treasury TARP funds and long-term government bonds to finance the purchases of illiquid mortgage assets. In total, the Federal Reserve System pumped over $1.5 trillion into the U.S. money supply in order to expand bank credit for the next economic recovery.

 

Government expenditures, fiscal deficits, and national debt

The federal government often spends more than tax revenue per year. The resultant annual fiscal deficits have driven up the national public debt of U.S. government to over $12 trillion. The national debt now exceeds $40,000 for every man, woman, and child in the nation! The U.S. government owes this national debt to U.S. banks, non-bank financial institutions, and private citizens who buy U.S. Treasury bonds. However, an increasing fraction of this public debt is held by foreign investors, such as China and Japan, who buy U.S. Treasury bonds. The current public debt is the highest in U.S. history in dollar terms (about 95% of total GDP).

 

Economic growth boosts tax revenues from year to year. The U.S. economic performance in the 1990s was much better than other economic episodes. Tax revenues grew faster than fiscal expenditures, and the federal government’s annual fiscal deficits began to decline over time. President Clinton and a Democrat-led Congress passed a major tax increase in 1993. After 1994, a Republican-led Congress slowed the growth of U.S. federal expenditures. Not surprisingly, both Democrats and Republicans claimed credit for ending almost 40 years of fiscal deficits in 1998.

 

After the terrorist attacks of September 2001, President Bush committed to reducing federal income taxes (despite new federal expenditures for national defense and homeland security). In his first year in office, President Bush pushed Congress to enact a major income tax cut. Democrats argued that this income tax cut contributed to the return to deficit-driven spending programs. Republicans argued that this tax cut would help stimulate the economy with better subsequent tax revenues and lower fiscal deficits. In 2003, President Bush succeeded in getting Congress to enact further tax cuts. However, large annual fiscal deficits continued through the end of the Bush administration. Large fiscal deficits and U.S. government debt would later remain nagging concerns for the Obama, Trump, and Biden administrations.

 

The U.S. President has the major responsibility for budget preparation through the Office of Management and Budget (OMB). The President and OMB Director devote substantial time to annual federal government budget preparation. Their staff members blue-pencil, revise, and make last-minute changes as well as the President’s message to Congress. After the budget is in legislative hands, the President may recommend further alterations as financial needs dictate. In an effort to consider the budget as a whole, Congress has established both House and Senate budget committees and a Congressional Budget Office (CBO) to review the President’s budget after its submission to Congress. These committees often draft a first budget resolution and then set forth target new goals to guide committee actions on specific appropriation and revenue measures. In Congress, a second budget resolution sets binding budget figures for committees and subcommittees with appropriations. In practice, however, the CBO often folds these budget resolutions into a single measure because Congress does not want to reargue the same issues. Congressional approval of annual spending programs often involves 13 separate appropriation bills. Each of these 13 bills covers separate broad categories of fiscal expenditures.

 

In terms of aggregate dollar amounts, Congress does not regularly make great changes in the executive budget. It is more likely for the federal government to shift money among fiscal spending programs and projects. Congress approves the budget in the common form of 13 appropriation bills, each of which provides for several departments and agencies. Once the budget passes in Congress, the President generally either approves or vetoes appropriation legislation in the next 10 days. Although Congress authorized the U.S. President to exercise a line-item veto in 1996, the Supreme Court declared it to be an unconstitutional violation of the separation of powers. The line-item veto would have given the President the authority to cancel specific expenditures and tax benefits in an overall appropriation act. However, the Supreme Court held that this procedure would transfer legislative power from Congress to the President.

 

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