College of Agriculture and Life Sciences. Academics. Research. Extension

Perspectives Online

« College names distinguished alumni | Main | N.C. State Faculty Member to Lead Agricultural Law Association»

YOU DECIDE: Can government steer the economic ship?

October 31, 2008

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

As it becomes more obvious the economy is now in a recession, the federal government is taking steps to try to ease the economic pain.

How is the government doing this, and what are the possible pitfalls and costs?

The federal government has two broad strategies at its disposal to try to steer the economic ship. One, controlled by the Federal Reserve (the "Fed"), is to manage the availability and cost of credit. The Fed uses this power to "lean against the economic wind" and promote steady economic growth with modest inflation.

This means that when the economy is booming and higher inflation is a threat, the Fed will increase the cost of credit - the interest rate - and strive to reduce lending and slow consumer spending. The purpose is not to decrease prosperity, but rather to increase prosperity at a consistent, sustained rate.

The Fed moves in the opposite direction when the economy is slumping. Here it lowers interest rates and increases the amount of money available for loans. The goal is to motivate consumers and businesses to borrow and spend more.

Can these actions work?

They can, but there are some issues. A big one is that the Fed's actions take time to gain traction: somewhere between six and 18 months. Also, even if credit is available and cheap, people and businesses still have to want to borrow. And to borrow, they have to have confidence about the economy. The Fed can't necessarily create this confidence.

There's also a possible cost of the Fed's policies, particularly those designed to fight a recession. If credit is made too easy and too cheap, excessive borrowing can lead to higher inflation.

The other arm of the government's economic policy is jointly controlled by the president and Congress and operated through the spending and tax policies of the federal budget.

The tactics are simple.

To fight a recession, the government tries to put more money in people's hands by cutting taxes and increasing public spending. Conversely, to subdue a boom, taxes are increased and spending curtailed.

An obvious question is where the government gets its money when it reduces taxes but increases spending. The answer: it borrows the money. In recent years, half the borrowing has come from domestic sources and half from foreign sources. In the original conception of this policy, the borrowing would be paid off when the government eventually increased taxes and decreased spending during an economic boom. But as most know, it hasn't worked out this way. So running up the national debt is a cost of this strategy.

Beyond this cost, there is some question whether temporary changes in government taxes and spending work any magic. Some analyses indicate the government actions may give the economy a temporary push or pull, but if businesses and consumers know the changes aren't lasting, they will only modestly alter their behavior.

Currently both strategies are being used by the federal government to fight the expanding recession. The Fed has lowered interest rates and increased credit. The government has also spent more money via a stimulus plan, with another stimulus shot being discussed.

But so far, the economy hasn't revived. Does this mean the government's policies have failed? Or would the economy be much worse without the policies?

You decide!

-30-

Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at October 31, 2008 08:00 AM