For those of you who do not wish to be bored with an indepth look at the economic policies of government, probably best not to read on. For the rest of you, welcome to lecture 4 of Econ101, "Government Economic Policies for Dummies".
The influence of government over the economy has always been strong. Once philosophical minds started to turn to production and trade in the 18th century, the original term for such studies was "political economy", highlighting the link between the state and the economy in general. The modern term "economics" was primarily incorporated into usage for the sake of simplicity.
Economic Objectives
The major role of Governments the world round is to improve the livelihoods of the people. In economic terms, this generally means increasing economic growth and real per capita income. However, not all countries follow this economic mantra. For example, Bhutan seeks simply to increase the happiness of its people, and puts focus on non-wealth factors as well. Also, the case that some Governments are primarily focussed on maintaining power to the detriment of the people could also be made. But overall, monarchs and politicians understand the importance of growing the wealth of the country and its people.
However, not all growth is the same and not all growth is good. Which is why most Governments delve a little deeper when setting their economic goals. Thus, the broad objectives to which most leaders strive for is stable and sustainable economic growth.
Stable Growth
Stability is seen as a key ingredient in maximising utility (happiness). For example, as a small business if you wanted to maximise the happiness of owners and staff, would it be best to be on a constant cycle of hiring three new staff members and then two months later firing a couple of people, or would it be best to simply hire 1 person every month or so? Instability or volatility increases transactions costs (in this example hiring, training, and redundancy costs) and decreases participant utility (job insecurity, dissatisfaction with management, etc). On a broader, national sense, instability in growth can lead to the same reduction in overall utility and poor social outcomes.
Sustainable Growth
Having a good, stable level of growth is great, but making sure it is sustainable for the life of the country (forever) is also paramount. Nauru is a good example of an unsustainable economy. In the late 60's, this small Pacific island nation was the richest in the world (per person). Their island had benefitted from an age of migratory bird droppings, which left behind easy to access phosphates. Over a few decades, they mined the island virtually dry of this useful mineral and failed to invest meaningfully in anything to keep their economy pushing along after the mining stopped. Now Nauru's people are among the poorest in the world and receives a large chunk of their income from Australian aid and now Australian immigration spending. A more common example seen through history and currently playing out in the Western world is non-sustainable growth from excess credit. The 80s and 90s saw relatively large and stable GDP growth in the US and developed nations, as interest rates were driven low and budget deficits became the norm. This, of course, started to unravel dramatically in 2007 and the results of unsustainable growth has been persistent low growth and the constant threat of recession in the US and much worse throughout Europe.
Policies for Growth
Which brings us to the question - What can Governments do the promote Stable and Sustainable Growth? Some would argue not much. These would say the market is the key determinant of economic swings and cycles. That Government policy is limp and only causes short term diversion from the true path of a nation's economy. These arguments have some merit, but to dismiss Government action and intervention would be like ignoring the influence of a foreman at a construction site. But to answer the question, in promoting stable and sustainable economic growth, the two big guns Governments have in their arsenal are:
- Monetary Policy - This is the game of central banks (RBA, Federal Reserve, ECB, etc) and usually sits independent of the Government and political party of the day. In essence this involves manipulating the level of liquidity and credit in the economy through the setting of interest rates and other money market manoeuvres. A big target for most central banks is maintaining low inflation, as high inflation is seen as an indicator of excessive growth. When credit is running too high, or the economy looks like overheating (growing too fast) the central bank can step in and raise interest rates in the hope of maintaining stability and sustainability. The opposite is occurring at the moment with fear of low growth leading most countries to reducing interest rates with the hope of encouraging the expansion of credit. Once rates get close to 0% (Japan, US, Europe, UK) monetary policy starts to lose its sting. The next option is to start buying bonds and other securities which pushes more money into the system and attempts to encourage greater investment and lending (quantitative easing).
- Fiscal Policy - The Government of the day can help increase/decrease economic activity through the level of taxes it claims and the amount of spending it looks to allocate to worthwhile infrastructure needs. Income redistribution is also seen as an important cog in maximising society's overall level of happiness. These policies are in addition to the automatic stabilisers that are inherent within a tax/welfare style system (i.e. in good times the fiscal position automatically tightens [lower deficit or higher surplus] due to higher tax receipts, and in bad times it loosens due to higher welfare payments [unemployment benefits]). Like monetary policy, fiscal policy can also start to become ineffectual if settings remain too loose during periods of trend or above trend economic growth. As most of the developed world is figuring out, cutting deficits (and running surpluses) should be done in times of plenty, not times of drought.
Obvious as it may seem, if Governments want to use these tools along with microeconomic policy settings (labour laws, deregulation, trade negotiations, etc) to create long-term, stable economic growth the first step should be to figure out what is the natural and sustainable growth level of the economy. However, most Governments and central banks tend to focus primarily on inflation and unemployment rates, as they are correctly seen as good (but not perfect) indicators of whether GDP is growing too fast (high inflation, low unemployment) or too slow (low inflation, high unemployment). Avoiding stagflation (high inflation and unemployment), hyperinflation (out of control inflation) and, to a lesser extent, deflation (negative inflation) are all seen as worthy and compulsory goals of most of the world's leaders, central bankers and finance ministers. We wish them all the best of luck.