Two contrasting historical episodes

In the decades following World War II, Keynesian ideas about countercyclical fiscal policy became increasingly popular among academic economists. This developing consensus received an official imprimatur when the 1962 Economic Report of the President— the annual publication produced by the President’s Council of Economic Advisers—made an explicit case for significant discretion in economic policy. “The task of economic stabilization cannot be left entirely to built-in stabilizers,” the report warned. “Discretionary budget policy, e.g., changes in tax rates or expenditure programmes, is indispensable—sometimes to reinforce, sometimes to offset, the effects of the stabilizers.” The council further argued that the government should have broad leeway to make such changes frequently, in response to evolving conditions: “In order to promote economic stability, the government should be able to change quickly tax rates or expenditure programs, and equally able to reverse its actions as circumstances change,” the report noted. According to the council, a similar logic must prevail in monetary policy—where “discretionary policy is essential, sometimes to reinforce, sometimes to mitigate or overcome, the monetary consequences of short-run fluctuations of economic activity.”

The epitome of interventionist economic policy, though, was the imposition of wage and price controls by the Richard Nixon administration in 1971 to combat inflation, which had climbed above 6% the previous year. The original 90-day freeze on nearly all wage and price increases expanded into a three-year experiment in discretionary inflation control—an experiment that ultimately failed as witnessed by the average inflation rate being above 11% in 1974.

These interventionist measures had the support of that era’s most prominent voices in monetary policy. Indeed, in 1972, Federal Reserve chairman Arthur Burns defended the administration’s efforts; the reason, he explained, was that “wage rates and prices no longer respond as they once did to the play of market forces.” He applied the same interventionist approach to his role at the Fed and the late 1960s and 1970s saw a series of discretionary adjustments of the money supply and interest rates.

A great deal of subsequent research has shown that the Fed’s responses to inflation were highly unstable over this period of discretion. Those responses can be divided into several distinct boom-bust periods, each of which saw the Fed ease and then sharply tighten the money supply. These measures induced contractions in economic activity, but the Fed then failed to sustain its tighter policy long enough to yield a lasting decline in inflation. Short-term thinking led to uneven and irregular monetary decisions.

This dynamic began to change as the 1980s dawned. Some prominent analyses of the effects of discretionary fiscal stimuli undermined the support for such policies among economists. On the practical side, the Ronald Reagan administration eschewed highly discretionary approaches in favour of greater reliance on fundamental (and permanent, rather than temporary) tax reforms.

This reliance on automatic stabilizers (rather than discretionary policies) in responding to the ups and downs of the business cycle continued through the 1990s, with very few—and very modest—exceptions. A very small stimulus was proposed by George H.W. Bush in 1992, but even this failed to pass in Congress. Another small stimulus was proposed by Bill Clinton in 1993, but it too failed to pass. By 1997, Northwestern University economist Martin Eichenbaum could write of the “widespread agreement that countercyclical discretionary fiscal policy is neither desirable nor politically feasible.”

A similar shift occurred in monetary policy, beginning with the Federal Reserve’s decision—starting in 1979 under the leadership of Paul Volcker—to focus its efforts on reining in inflation. This marked a dramatic change from most of the 1970s, when the Fed repeatedly switched emphasis from unemployment to inflation and back again. Volcker noted in 1983 that the Fed had “gone a long way toward changing the trends of the past decade and more.” His successor, Alan Greenspan, maintained this commitment to price stability through the 1980s and 1990s.

The Fed also showed a greater appreciation for the importance of predictability and transparency in its decisions. In the 1970s, decisions about interest rates were hidden within the Fed’s announcements about its borrowed reserves. By the early 1990s, however, the Fed was announcing its interest-rate decisions immediately after making them, and was even publicly explaining its expectations and intentions for the future.

The empirical evidence, too, plainly demonstrates that monetary policy corresponded far more closely to simple policy rules in the 1980s and 1990s than it had in the previous two.

Krishnamurthy Subramanian,is an assistant professor of finance at the Indian School of Business

This is the second part of a four-part series. Comments are welcome at theirview@livemint.com