Changing perspectives in the Economic Reports of the President
Caption: John Kerry and George Bush devoted an entire evening debate to their ultimate goals of economic policy during the 2000 presidential election campaign. Courtesy: Issues2000.org
The contrast in our book between new classical and Keynesian perspectives may be overly simple, but you can see it in the Economic Report of the President which the Council of Economic Advisors (CEA) puts out each January or February.
American presidents recruit economists whom they believe to be sympathetic to their own economic outlook. John F. Kennedy was a liberal Democrat and President from 1961-1963 who believed that the government should play an active role in remedying economic problems. So when he became President in 1961 he selected Keynesian economists to be on his council. Read this fragment from their 1962 report, shining with faith in government action. Keynesian or Abba Lerner-style spending (functional finance) is presented as the solution to the recession that the U.S. economy was experiencing at the time (but note its confession of the problem of time lags and uncertainty):
Government fiscal and monetary policies contributed strongly to the favorable economic developments of the past year. [Would a Council dominated by new classical economists write something like this?] Although the downswing probably would have ended early in 1961 in any case, the impressive pace of the economic expansion must be attributed in large measure to government actions. . . . The prospect for 1962 is a continuation of the favorable trend of 1961. Whether the current expansion is sufficiently strong and durable to carry the economy to "maximum employment, production, and purchasing power," no one can now foretell with certainty. Current and proposed government actions will continue to give strong support to economic expansion (Economic Report of the President 1962, p. 39).
Twenty years later, in a very different political and cultural climate, and ten years after the break-down of the Phillips Curve, another perspective on policy would appear in the Economic Report. In January 1981 Ronald Reagan, a conservative Republican, had become President (and remained President until January 1989). The next fragment is taken from Reagan's first report (1982). Notice the talk about the free market and the warnings against big government:
The speed with which the economy adjusts to the Administration's policies will be largely determined by the extent to which individuals, at home and at work, believe the Administration with maintain, unchanged, its basic approach to personal and business taxation, Federal spending and regulation, and monetary policy. When public expectations fully adjust to this commitment, a necessary condition for both reduced inflation and higher [economic] growth will be fully established. In short, as this Report tries to demonstrate, what some people have referred to as "monetarism" and "supply-side economics" should be seen as two sides of the same coin-compatible and necessary measures to both reduce inflation and increase economic growth (Economic Report of the President 1982, p. 21).
Reagan's economists were not clones of academic monetarist or new classical economists. Still, monetarist and new classical they largely were. Notice the emphasis on expectations and the talk about lower tax rates ("supply-side economics") unleashing entrepreneurial energy, promising (implicitly) to generate more savings, and improving the incentives to work. Contrary to many academic monetarists and new classicals, who want a strictly laissez-faire policy, the Reagan economists wanted the government to take action. Because the actions were targeted to affect the supply side of the economy they were called "supply-side economists".
The monetarist and new classical language is most apparent in a 1992 fragment from the second report of the Council of Economic Advisors that Reagan's successor, the Republican George Bush, appointed. Here one finds unequivocal support of the free market and no promises that government fiscal policy can do anything to fight the recession of the time:
The current economic difficulties in the United States and other industrial countries should not obscure the fundamental strengths of market economies. The United States is the world's best example of the interrelated strengths of democratic pluralism and market-oriented economies. Americans have the highest standard of living in the world. U.S. gross domestic product per capita [is] . . . more than 35 percent above Germany and 25 percent above Japan, when using purchasing power equivalents. . . . The collapse of central planning and communism [especially in the former Soviet bloc but also in Africa, Asia, and Latin America] . . . was, in large part, a consequence of these command systems' inability to provide their populations with adequate standards of living and personal freedoms (Economic Report of the President 1992, p. 22).
The non-committal position of Bush's Council was notable. Americans had grown used to a government that would intervene in case of trouble. Jimmy Carter had won the Presidential elections of 1976 with promises of vigorous government actions, but lost in 1980 because in the eyes of many voters he had failed to make good on his promises. Carter lost to a Reagan who promised vigorous government action--even if his objective was the reinforcement of free markets. And then, in 1991, Bush announced that `laissez-faire' is the best policy. Yet in 1992 this laissez faire president had to acknowledge that the government has to do something to turn the economic tide. This goes to show that in the nineties pragmatism and prudence became the key-words in the motivation of economic policies. Although the current political leadership continues to advertise its commitment to free-market policies, it recognizes the need for government intervention. Listen to the opening words of The Economic Report of the President released during the presidential election year of 2000 (ending in George W. Bush's second term victory):
The policy strategy of maintaining fiscal discipline, investing in people and technologies, and opening international markets has borne rich fruit, allowing the Nation to exploit new opportunities and reap the benefits of major scientific and technical advances (p. 21).
And again in 2002, following the terrorist attack on the World Trade Towers and the Pentagon and the attending slow-down in economic growth:
Over the past two decades, the Nation has witnessed an impressive increase in prosperity. Over 35 million jobs were created, and real income nearly doubled, producing an unprecedented standard of living. This economic success also serves as an example of what an open, free market economy-one that relies on the private sector as the engine of growth-can achieve. . . . Government spending-Federal, state, and local levels combined-added to economic activity over the first three quarters of the year [year 2001]. Government spending increased at a 2.9 percent annual rate during this period (pp. 23, 29).
In other words, theory does shape policy. Since the 1960s the U.S. has pursued several distinct economic theories. The Economic Report of the President is one proof of it.
Rules Versus Discretion
The notion of instrumental rationality derives from the philosophy of David Hume and has been refined or refuted by neoclassical economists, game theorists, cognitive psychologists, and philosophers. Rational economic agents are said to be instrumentally rational when they choose an optimal mix of means to achieve ends which are already given. By contrast, communicative rationality is a broader notion of rationality acknowledging the pivotal role that dialogue can have on both the means and the ends.
The policy debate between the monetarists, new classicals, and libertarians on one side and the Keynesians and other interventionists on the other can also be viewed as a debate about "rules versus discretion". The active policies advocates by Keynesians are discretionary policies, because they leave policy makers with the discretion to intervene in the economy. New classicals and monetarists are opposed to such discretionary policies and advocate that policy makers simply follow rules, in accordance with the recommendation of public choice theorists. One example is the constant money-growth rule, another the rule that requires the federal government to balance its budget.
Discretionary policy is activist; it refers to specific actions that the government takes to influence the economy
A policy according to rules is a passive policy. The rules prescribe policy outcomes and hence exclude discretionary actions.
In 1960 the monetarist Milton Friedman gave the following justification for the constant money-growth rule:
There is little to be said in theory for [the] rule ... The case for it is entirely that it would work in practice. There are persuasive theoretical grounds for desiring to vary the rate of growth to offset other factors. The difficulty is that, in practice, we do not know how to do so and by how much. In practice, therefore, deviations from the simple rule have been destabilizing rather than the reverse.
Friedman's was a practical argument: economists would not know enough to tell policy makers how to manipulate the policy instruments in order to get the desired results. (Recall Herbert Stein's pessimistic syllogism.) Another argument against the use of discretionary policies is the so-called incredibility effect. Such a policy, so Friedman and others have argued, works only if it fools people and but you cannot fool people all the time. Continuing use of discretionary policies would render them incredible and thus ineffective.
The incredibility effect is alleged to occur when discretionary policies are used repeatedly.
James Buchanan, another Nobel laureate and (we've noted) a major proponent of the public choice perspective, adds the political argument that discretionary policies will inevitably be used to further the interests of the politicians and those who support them. To avoid political games with the economy as the stake he advocates the constitutional enforcement of rules.
The new classical economists subscribe to the outlook of Friedman and Buchanan. Keynesian economists do not. The late Keynesian and Nobel Laureate James Tobin argued for example:
I don't think that [a policy rule] is actually functional. I notice that rules usually come down to being very simple rules. [..] You just cannot write the formula down in sufficient detail to cover all the things that might happen. Therefore, I think that the idea of rules versus discretion is an overdrawn dichotomy. If we incorporate new information for the determination of policy, and I think we should, the policy is bound to become discretionary.
In short, because of new information and, we may expect, advances in economic knowledge, policy makers do well to change the rules. And changing the rules is a discretionary policy.
But what about Friedman's ignorance argument? To that Olivier Blanchard and Stanley Fisher, two new Keynesian economists, respond with another practical argument: "Working economists, like doctors treating cancer, cannot wait for all the answers to analyze events and help policy." So economists should work with the best they have. In their judgment that means discretionary actions from time to time.
The debate plays itself out in the actual policies pursued. Let's look at fiscal policy first.