Economic Policy Making

GOVT 2305

The term economic policy refers to the various policies that relate to the

development and promotion of the economic system in the U.S.

In this section we’ll walk through the development of economic policy in the United States and look at the current issues associated

with it.

We’ll conclude with a look at the various actors involved in the creation of economic policy and

note which interests tend to dominate it.

Economic policy is not neutral – some interests are better served than others.

For some history, click here on these blog tags.

economic policymakingfiscal policy

monetary policy

Constitutional History

If you remember from earlier sections in this class, one of the driving forces behind

the establishment of the current constitution was the effort of the

commercial classes – the Federalists - to enhance the viability of business interests.

They sought to create a commercial republic.

Competition between the states, in their opinion, undermining the ability of the

nation to prosper.

This explains a number of the delegated powers granted to the national government in Article

One, Section Eight. It also explains some of the limits placed on the powers of states in Article

One, Section Ten.

As a result, states were prohibited from engaging in activities which could undermine the collective

economic viability of the nation.

Key commercial powers were given to the national government so

they could be uniformly applied across the nation.

But states also retain certain powers to provide services and regulate industry within its borders.

These fall under the heading of the reserved powers guaranteed to the states in the 10th

Amendment.

We discuss these in GOVT 2306 when we cover state economic policymaking, with a special

emphasis on Texas.

Free Market Economics

Remember that the United States was founded the same year that Adam Smith published An Inquiry into the Nature and

Causes of the Wealth of Nations.

This is significant because the United States’ economic system is based in large

measure on the principles Smith advocates in that book.

A key theme in Smith’s work is that governmental interference in the marketplace

constricts industrial growth, and with it an increase in a nation’s wealth and a long term enhancement of the well being of its citizens.

The public good is better achieved by allowing people the ability to complete freely in a free

market.

A free market provides greater opportunities for needs to be

addressed by allowing decisions to be made by participants in the

marketplace.

It also allows for the entrepreneurial nature of private

persons to be unleashed.

Smith assumed that people are naturally inclined to trade:

“The propensity to truck, barter and exchange one thing for

another is common to all men, and to be found in no other race of

animals.”

The wealth of a nation – and the well being of the population – is

more likely to be obtained if people are able to make economic decisions, that is if the process is

decentralized.

Centralized decision making constrains economic growth.

Among those decisions made by individuals in the marketplace was the

decision to create a division of labor in the production of goods.

This increased efficiency and productivity. The same number of workers – with fewer

skills – can produce a greater number of items.

A nation’s wealth is not based on how much gold it holds, but in how

productive its workforce is.

Mercantilism

Note that many of the arguments used against mercantilism are used later against socialism and communism, which are also economic systems that include centralized

controls.

In fact a question we will raise soon is what aspects of the economy should be

centrally managed and which should not.

Property Rights

Capitalism

Smith’s arguments are based on the primacy of property rights, which were

also a concern of the framers of the Constitution. Many were among the

minority of the population who were large scale property owners. They were

concerned about actions on the part of some states to redistribute property

following the revolution.

Remember this phrase from Fed 10?

“A rage for paper money, for an abolition of debts, for an equal division of property, or for any other improper or wicked project, will be

less apt to pervade the whole body of the Union than a particular member of it . . . “

Federalists were concerned that their rights were likely to be

violated by the populist majorities in the states.

The design of the national government would check those

majorities by breaking them apart.

The existence of property rights implies that people are able to

possess capital.

The free market allows people to invest that capital as they choose.

Smith is often claimed to be the founding father of capitalism.

He pointed out the benefits associated with it.

“It is not from the benevolence of the butcher, the brewer, or the

baker that we expect our dinner, but from their regard to their own

interest.” – Adam Smith

Remember that James Madison assumed that people would be

motivated primarily by their self interest. Adam Smith argued that this

compulsion has it benefits.

The idea that people are primarily motivated by their own self interest is

implicit in at least one of the delegated powers in the Constitution.

The patent clause: “The Congress shall have the power . . . to

promote the progress of science and useful arts, by securing for

limited times to authors and inventors the exclusive right to

their respective writings and discoveries”

This assumes that people are motivated to create by the

promise of creating wealth for themselves.

But even the Federalists wanted some services provided by the national government, meaning

that they are meant to promote the common good – or the general

welfare.

DefenseCentral Banking

This explains the development of the early executive agencies.

Particularly the Treasury Department, which was originally

headed by Alexander Hamilton who wanted to aggressively use

national power to promote economic development.

He produced three reports to Congress which outlined his goals

for the American economy and how best to pursue them.

Many activities of the national government through the 19th

Century were based on Hamilton’s recommendations.

First Report on the Public Credit

Here Hamilton makes recommendations designed to enhance the credit worthiness of the nation. He urged that government securities be redeemed at face value and the national government assume all state

debt assumed during the revolutionary war.

Maintaining a high credit rating remains a concern

Second Report on Public Credit

Here Hamilton argued for the establishment of a national bank. This would act as a central bank

that would issue federal bank notes and provide stability and

flexibility for the financial system.

This led to the chartering of the First and then the Second Bank of

the United States.

Adam Smith argued that a banking industry is necessary to enhance

productivity.

“It is not by augmenting the capital of the country, but by rendering a greater part of

that capital active and productive than would otherwise be so, that the most judicious operations of banking can

increase the industry of the country.”

This was a controversial proposal. Proponents of limited government

protested the bank.

The constitutionality of the bank was challenged, but upheld in a

major early Supreme Court case: McCullough v Maryland.

The bank was not authorized in the Constitution, but was instead argued to be

justified by the necessary and proper clause.

It would continue to be politically divisive. Federalists supported it, Democrat-

Republicans did not. In 1832 Andrew Jackson vetoed a bill re-chartering the

bank.

After a brief boom following the veto, in 1837 the US had an

economic crisis that lasted until the mid 1840s.

One of the arguments in favor of central banks is that they can help

prevent – or at least lessen the impact of – financial panics.

We will discuss this further when we look at monetary policy.

The Federal Reserve System acts as a central bank today.

Report on Manufactures

This is the third report produced by Hamilton. In it he argues that the national government should actively promote the

growth of manufacturing. Tariffs on imports should be imposed in order to

raise revenue in order to provide subsidies for American industry.

He also argued in favor of investing in internal improvements –

infrastructure- in order to make it easier for commerce to be

transported.

The acquisition of western lands made internal improvements

necessary.

Later infrastructure projects included rail projects funded by

land grants and an interstate highway system.

Subsidies and infrastructure projects were controversial at the time and remain so.

They were supported by the Federalists, and later the Whig Party and Republican Party, but opposed by the Democrat-Republican and later

the Democratic Party.

Current controversies exist regarding whether funds should be spent to replace aging

infrastructure, and whether items such as bullet trains are worth developing.

The use of subsidies to foster specifics industries has become

especially controversial, especially since those industries can develop

sufficient political power to maintain subsidies even though

they may no longer be necessary.

Case in point: Farm Subsidies.

The resulting relationships lead to the development of the iron triangles we discussed in a

previous section.

Sometimes they go be the name of the “______ industrial complex.”

The most famous of which is Eisenhower’s term, the “military

industrial complex.”

Other terms include the prison, charitable, medical, college, and

others.

The point is that once a sector of the economy receives benefits –

be they subsidies or other benefits – it is very difficult to get rid of

them.

The American School of Economics

Altogether Hamilton’s proposals developed what came to be known as the

American School of Economics, or the American System.

It held that the national government should actively promote the development

of American industry three ways:

Notable examples of government intervention in the period prior to the Civil War include the establishment of the Patent Office in 1802; the

establishment of the Office of Standard Weights and Measures in 1830; the creation of the Coast and Geodetic Survey in 1807 and other measures to improve river and harbor navigation; the various Army expeditions to the

west, beginning with Lewis and Clark's Corps of Discovery in 1804 and continuing into the 1870s, almost always under the direction of an officer

from the Army Corps of Topographical Engineers, and which provided crucial information for the overland pioneers that followed; the assignment of Army

Engineer officers to assist or direct the surveying and construction of the early railroads and canals; the establishment of the First Bank of the United States and Second Bank of the United States as well as various protectionist

measures (e.g., the tariff of 1828). - source

1 – protective tariffs2 – infrastructure development

3 – banking policies that promoted production not speculation

Two major changes have occurred in the years since.

1 - Protective tariffs have fallen out of favor since they are argued to suppress trade.

American policy is more likely to be committed to free trade.

2 – The banking and financial sector is more willing to focus on speculation and is not necessarily oriented to wards enhancing

productivity.

From the beginning, the US has been a capitalist economic system.

But capitalism has its negative aspects as well, which has led to an expansion of

government over American history. A lot of the controversies in contemporary

politics stem from this expansion.

One consequence is greater economic inequality. This can lead to instability in

society.

“No society can surely be flourishing and happy, of which the

far greater part of the members are poor and miserable.” – Adam

Smith

Market Failure

It may be best to describe this expansion and the associated

controversies by first looking at the concept of market failure.

The ideal marketplace is argued to be able to provide goods and

services efficiently.

It assumes (1) that demand will always be supplied, (2) that demanders of a good or service cannot be overcharged because

there are always other places a good can be purchased, (3) that demanders and

suppliers have the ability to make sensible decisions about what something is actually

worth, and (4) that the costs associated with producing items will be efficiently

borne by the consumers of that product.

This is not necessarily true.

Markets are argued to fail in four significant ways, and each of these

helps explain certain key areas where government engages in the marketplace. These are the four areas, the four things that make

markets fail.

MonopoliesNegative Externalities

Public GoodsUneven Information

All of these undermine free market principles and can be used to

justify governmental intervention.

There is a school of thought that even here government should not intervene however. This is called

laissez-faire.

Monopolies

A monopoly – or its cousin the oligopoly – occurs when there is only one provider of a

good or service. The lack of competition prevents people from going elsewhere to purchase an overpriced, or poorly made product, meaning that the producer can

charge whatever they choose and make it as poorly as they wish. If the product is a

necessity, this can lead to abuse.

Monopolies undermine competition, which is the heart of

a free market system.

That being the case, the solution has been to allow the national

government to break apart monopolies in order to ensure that

competition exists.

The 1890 Sherman Antitrust Act prohibited anti competitive

activities, declared trusts to be illegal and provided a mechanism

for breaking it apart.

Standard Oil was broken into 33 companies in 1911 due to the

accusation that it was a monopoly.

The action was found to be legal in the case of Standard Oil Company

of New Jersey v. United States.

It was based on the commerce clause of course.

The Federal Trade Commission has jurisdiction over both consumer protection and anti-competitive

business practices. The Bureau of Competition has jurisdiction over monopolies, which is shares with

the Antitrust Division of the Department of Justice.

The FTC also has the power to oversee proposed mergers and

denying them if they believe the merger would create a monopoly,

or decrease competition.

Click here for the FTC Guide to the Antitrust Laws.

Negative Externalities

An externality is a cost or benefit imposed on a party as a result of an economic transaction that

they were not a participant of. Positive externalities benefit non-participants – these

might happen when someone decides to purchase a rundown house in a neighborhood

and improves it

Negative externalities occur when a transaction between two people

– a demander and a supplier – imposes a cost on third parties.

These can be any number of things, but the most common type

is pollution.

Pollution is a by-product of the manufacturing of certain products, and generally occurs

because the producer did not spend the money necessary to prevent it.

The reason they did so of course was to keep costs low. The cheaper it is to produce the product, the cheaper the price and/or the

greater the profits. Since clean up costs money, it results in greater costs of production, meaning

a higher price or lower profits.

Producers tend to not like that, so they pollute if possible. But this means that the costs of production will borne by others, and they are unlikely to be third parties.

These can be people who live near a factory, or whose water supply is affected

by careless disposal of a by-product.

This violates a principle of the free market.

Environmental rules basically force the producers of goods to spend the money to minimize pollution by spending money on clean-up and passing those costs onto the

consumers of the product.

This is what justifies the existence of the Environmental Protection Agency for

example.

Public Goods

A public good has two characteristics. It is non-excludable and it is non-rivalrous. This

simply means that its use by one person cannot negate the ability of another person to use it as well. This makes it

different than a private good the consumption of which can be limited.

Think of the difference between a hamburger and a street light.

Is a Laissez-Faire system a free market system?

Some background on the US economic system.

The United States has a capitalist economic system.

economy is mixed. It contains a balance between goods and

services provided by the public and private sectors.

Striking that balance is a source of constant conflict. Conservatives –

generally support private enterprise – liberals (with

exceptions) support the public provisions of good and services.

Question: Are certain goods and services best provided by the

public sector? And are other goods and services best provided by the

private sector?

The ongoing question about universal health care is an

example.

More importantly, how can it be determined which is which?

And is that decision made dispassionately on objective

criteria or is it driven by political self insterest?

Examples of publicly provided services:

military protectionpolice and fire protection

educationpublic utilities

health care for the poor and elderly

Examples of privately provided services:

Design, manufacturing and sale of consumer products

Agriculture

Many of these services are provided by business large and

small

Wal-MartMicrosoft

AppleExxon-Mobil

Both the private and public sector have advantages and

disadvantages.

An advantage of the private sector is its efficiency and rapid response to changing

circumstances, but it tends to only provide services to those who can afford it.

An advantage of the public sector is stability and that goods and services are provided equally, but it can be inefficient

in doing so.

In many places, the economy of the US is mixed.

Some items can be provided by both the public and private sector,

which can lead to conflict.

The recent fight over health insurance is a perfect example.

Should the market, solely, determine who gets health

insurance, or can government step in and ensure that insurance should be made available to

everyone?

Over the course of American history, national, state and local governments have expanded the range of services they provide.

Also:

Social SecurityMedicareMedicaid

Since the 1930s, government has stepped in to provide services the private sector had no interest in

providing.

This will be a subject we will cover in more depth when we discuss

the executive branch.

These also happen to be some of the most expensive programs run

by government.

Social SecurityMedicareMedicaid

Some arguments (political and economic) are made that these

services ought to be provided by the private sector because they can perform them cheaply and

more efficiently.

For example: In Iraq, could private contractors do a better job than

the military?

Blackwater

Can the private sector provide old age pensions and postal service

better than government?

One of the economic functions of the federal government has been

the promotion of the private sector.

The commercial powers in the Constitution were intended in may

ways to foster business development by providing a solid

financial foundation, basic security, and policies meant to absorb risk.

BankruptcyUniform Weights and Measures

Patent ProtectionPost Offices

Hamilton Recommended a series of measures to Congress intended to spur commercial development

First Report on the Public Credit.Operations of the Act Laying Duties on

Imports.Second Report on Public Credit.

Report on the Establishment of a Mint.Report on Manufactures.

Protectionism

Technological development has often been subsidized by the

national government.

Often through the military.

FinanceSteamshipsTelegraphRailroads ElectricityAirplanes

RadioTelevisionComputerAerospace

The Internet

For many industries, the national government is their largest client.

Proponents of these expenditures argue that they enhance basic

research and establish the foundation on which consumer

products can evolve.

Example: the web.

Opponents argue that private enterprise can fund basic research,

and that this funding fosters the development if sub governments

and issue networks.

Chief example: Eisenhower’s Military Industrial Complex.

An additional fight concerns whether transactions in the

marketplace should be subject to regulations.

The private sector tends to not like regulations since they can limit

profits.

(unless they can capture the regulatory agency and regulate

themselves)

As additional services are provided. The costs of government increases. This leads to problems

associated with budgeting.

As we will see, over the past few decades, an imbalance has emerged between federal

revenues and expenditures.

Question: Are certain goods and services best provided by the

public sector? And are other goods and services best provided by the

private sector?

More importantly, how can it be determined which is which?

And is that decision made dispassionately on objective

criteria or is it driven by political self insterest?

Examples of publicly provided services:

military protectionpolice and fire protection

educationpublic utilities

Social SecurityMedicareMedicaid

K – 12 Educationetc…

Examples of privately provided services:

Design, manufacturing and sale of consumer products

Agriculture

WalMartMicrosoft

AppleExxon-Mobil

An advantage of the private sector is its efficiency and rapid response

to changing circumstances.

An advantage of the public sector is stability and that goods and services are provided equally.

Some items can be provided by both the public and private sector,

which can lead to conflict.

The recent fight over health insurance is a perfect example.

Should the market, solely, determine who gets health

insurance, or can government step in and ensure that insurance should be made available to

everyone?

Over the course of American history, national, state and local governments have expanded the range of services they provide.

Since the 1930s, government has stepped in to provide services the private sector had no interest in

providing.

This will be a subject we will cover in more depth when we discuss

the executive branch.

These also happen to be some of the most expensive programs run

by government.

Social SecurityMedicareMedicaid

Some arguments (political and economic) are made that these

services ought to be provided by the private sector because they can perform them cheaply and

more efficiently.

For example: In Iraq, could private contractors do a better job than

the military?

Blackwater

Can the private sector provide old age pensions and postal service

better than government?

One of the economic functions of the federal government has been

the promotion of the private sector.

The commercial powers in the Constitution were intended in may

ways to foster business development by providing a solid

financial foundation, basic security, and policies meant to absorb risk.

BankruptcyUniform Weights and Measures

Patent ProtectionPost Offices

Hamilton Recommended a series of measures to Congress intended to spur commercial development

First Report on the Public Credit.Operations of the Act Laying Duties on

Imports.Second Report on Public Credit.

Report on the Establishment of a Mint.Report on Manufactures.

Protectionism

Technological development has often been subsidized by the

national government.

Often through the military.

FinanceSteamshipsTelegraphRailroads ElectricityAirplanes

RadioTelevisionComputerAerospace

The Internet

For many industries, the national government is their largest client.

Proponents of these expenditures argue that they enhance basic

research and establish the foundation on which consumer

products can evolve.

Example: the web.

Opponents argue that private enterprise can fund basic research,

and that this funding fosters the development if sub governments

and issue networks.

Chief example: Eisenhower’s Military Industrial Complex.

An additional fight concerns whether transactions in the

marketplace should be subject to regulations.

The private sector tends to not like regulations since they can limit

profits.

(unless they can capture the regulatory agency and regulate

themselves)