Policy Making
19. Institutional policies

Fiscal and monetary policies are not the only options that a President could use to reverse a downturn in the economy. Government can also change the rules of the economic game. The U.S. government could, for instance, abolish free markets and assign to economists the task of planning and controlling all economic decisions. Or, at the other extreme, the government could scrap all regulations. Either action would have large macroeconomic consequences.

These dramatic choices are not as improbable as they seem at first. Look at other countries. Especially around the year 1990 we witnessed many such changes. Take the Eastern European countries and those of the former Soviet Union. In the course of a few years they have moved from centrally planned economies to market economies, based on free enterprise, flexible prices, and international currency exchange. Dramatic changes in the economic rules also occurred in Latin American countries. In 1990 the Brazilian government froze bank accounts, slashed its own spending, and forbade price increases, in a desperate attempt (by no means the first in recent Brazilian history) to bring hyperinflation under control. India is moving into the free market column. China is not far behind. You can bet that the world looks different to the economic actors after such interventions. The fiscal and monetary policies we discussed above are by comparison mild.

The U.S. government continually alters the economic rules, if rarely so extensively. The Civil War in the 1860s and the Great Depression of the 1930s are the only periods in which American policy has taken enormous leaps. At other times it regulates or deregulates, imposes or lifts tariffs on imports, institutes subsidies for some enterprises (farms, for example, in the late 1930s) and abolishes them (in the 1990s), sends delegations abroad to promote U.S. businesses, and conducts a war from time to time. In many cases the intentions are not macroeconomic. Deregulating the telephone industry presumably serves the microeconomic purpose of ending a monopoly; and fighting a war has purposes such as defending democratic values and keeping world peace. Yet these actions can serve macroeconomic aims as well. Figure 33-10 shows the model.

Figure 33-10 Institutional Policies according to the Tinbergen Model
  • Tastes
    • Ultimate Goals
      - Economic growth
      - Low unemployment
      - Low inflation
      - Stability
  • Constraints and Tools
    • Intermediate Targets
      - Institutions (tax codes, regulations, protective measures, training programs, government support for industries, etc)
    • Policy Instruments
      - The law
      Government programs

The major instrument of institutional economic policies is the law. The intermediate targets are the many institutional arrangements in which a market economy is embedded. We shall mention a few.

Income and price policies

To fight inflation, for example, monetary and fiscal policies may be insufficient. The Keynesian James Tobin, among others, has suggested that the government conduct an "incomes policy", regulating the increases in wages and salaries. An incomes policy is a deal between workers and capitalists to share out the gains from economic growth in a fair and orderly fashion. Tobin's justification is his belief that inflation is mainly caused by increases in costs (see Chapter 29) rather than increases in the money supply or aggregate demand. Another possibility for controlling inflation is the direct control of prices.

In the United States income and price controls have been part of policy from time to time. In World War I and much more extensively in World War II they were tried with the full force of legal compulsion. Kennedy tried to influence price increases by "jawboning" (that is, trying to persuade businesspeople and unions to moderate their price increases). President Nixon actually imposed wage and price controls--a startling thing for a Republican president to do, though less startling at the time--and President Carter tried more jawboning. Public sentiment, however, including the sentiment of American economists, is not favorable to such interventions in the rules of the game. European and Asian countries have a more favorable social and political climate for incomes policy. In the Northern European countries in particular the governments participate in wage negotiations and often exert a moderating influence on inflation, applying a mix of persuasion and compulsion to their economic leaders.

Labor market policies

Sweden has had low unemployment since World War II. Extensive government involvement in the labor market appears to be an important factor. Once unemployed a Swedish worker must participate in an employment program, including retraining if necessary. Unemployment benefits are generous, but tied to interventions in the worker's career.

Recall from earlier chapters that the functioning of the labor market is central to macroeconomics, whether Keynesian or new classical. And the labor market is an important object of policy in its own right. Labor market policies can be justified most easily when unemployment is due to mismatch of the supply of and demand for labor, and when the labor market does not remedy the problem quickly enough. The mismatch can be due to differences in skills supplied and demanded (as when only computer jobs are available to unemployed steelworkers) or to misallocation of labor across regions (an excess in Texas and a shortage in Washington D.C.). Conventional economic theory says that an adjustment in wages will be sufficient to channel labor and its skills to where it is needed most. "Mismatch" is a problem if the market adjusts slowly. If it does not, or is perceived so, then the government may step in and alter the rules of the labor market. The government can for example open agencies that mediate between the buyers and sellers of labor, set up training programs, or open factories where people find temporary jobs to gain experience.

Industrial policies

For some years the economic miracles of East Asian economies have baffled some western observers. (American journalists tend to have cycles of bafflement when other countries do well: Sweden in the 1950s, Germany and France in the 1960s, Japan in the 1980s). One explanation has been cultural: it was believed that the Japanese, Koreans, Taiwanese, Thais and Singaporeans simply were willing to make great sacrifices in the form of hard work and high savings. There may be something to this explanation although it does not tell what changed--since no one in 1955 would have predicted the success of the new "East Asian Giants." Forty years ago these countries--except Japan, which had embarked on economic growth much earlier--were exceedingly poor. Another explanation is that each of these countries succeeded in mixing liberal (free market) policies with an industrial policy.

Industrial policy is any policy that targets selected industries and enterprises and promotes their interests through subsidies, tax breaks, technological assistance, provision of infrastructure, advocacy, and other means.

Industrial policy in each of these countries was designed to promote manufacturing goods for export, similar to the attempts of state and local governments in the United States to encourage industry. The policy included subsidies, tax breaks, support for imports of inputs and protection against the import of competing products. In South Korea the government was accustomed to taking charge in the initial stages of a new industry and running the enterprise itself; it would also grant monopoly rights to private enterprises that proved to be most effective on foreign markets.

In the United States the topic of industrial policy at the national level is controversial. From time to time a politician will argue for an industrial policy, but usually he loses the debate. Many politicians and most likely the majority of economists are wary of any form of industrial policy. They argue that the government should not get involved in the game of picking winners and losers, leaving the task to markets. The fear is that industrial policy will be exploited by politicians and businesses for special privileges and extra profit, as it in fact has on a large scale in Japan.

Yet U.S. economic policy is already industrial to some extent. The U.S. government subsidizes certain industries, protects others, helps American companies with large orders from the Pentagon (the peace dividend--lower expenditures on arms--may change this one), now and then bails out a large automaker, and steps in when the banking industry gets into trouble. Its extensive interventions in agriculture could also be called an "industrial" policy. States and cities, as we have noted, will give tax breaks when they are particularly interested in attracting a certain industry. In short, the industrial policy of the United States is not a small matter even now. The controversy is about whether it should expand.

International institutional policies

Many of the institutional policies mentioned have an international dimension. Some agricultural policy, for example, is designed to protect American producers against foreign imports, such as sugar. (The American price of sugar is three times the world price). More of it is aimed at encouraging American exports of wheat, soybeans, tobacco, timber, and the like. The international dimension of farm policy is more important in Europe, which has long been an importer of agricultural goods and had a large farm population until recently.

Policies of protection and free trade affect the macroeconomy more powerfully than is commonly recognized. When the United States functions in a world market it is forced to adjust to world conditions. Increasingly the macroeconomic policy of all countries is caught in a global web. There is no way to get free of the web and still keep the benefits of world specialization.

Thanks to various institutional policies are the U.S. and the rest of the world gradually removing the worst of trade barriers. In 1994 a large bloc of countries concluded lengthy negotiations in the context of GATT, which stands for General Agreement on Tariff and Trade. The result is the drastic lowering of tariffs, and enforcement of intellectual property rights. Another memorable institutional policy was the passing of the NAFTA treaty in 1993 which prepared the way for basically unimpeded trade among the U.S., Mexico, and Canada.