Question

Define discretionary measures and automatic stabilisers. Give examples. State the problems policy-makers face when using discretionary policy measures. Discuss the advantages of “automatic stabilisers” over “discretionary measures

Answer 1

DISCRETIONARY MEASURES

Discretionary measures in a fiscal policy are based on the judgment of policymakers in the moment as opposed to policy set by predetermined rules. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program. These are actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.

Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program. Some recent examples of these in the US are the 2008 one-time tax rebates under the Economic Stimulus Act and the $831 billion in federal direct subsidies, tax breaks, and infrastructure spending under 2009 American Reinvestment and Recovery Act.

AUTOMATIC STABILIZERS

Automatic stabilizers are a type of fiscal policy designed to offset fluctuations in a nation's economic activity through their normal operation without additional, timely authorization by the government or policymakers. The best-known automatic stabilizers are progressively graduated corporate and personal income taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are so called because they act to stabilize economic cycles and are automatically triggered without additional government action.

There are a number of issues that make discretionary fiscal policy more difficult:

1. FISCAL POLICY AND INTEREST RATES - An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand. Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up being less powerful than was originally expected. This is referred to as crowding out, where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.

2. LONG AND VARIABLE TIME LAGS - Monetary policy can be changed several times each year, but fiscal policy is much slower to be enacted. Imagine that the economy starts to slow down. It often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. The time it takes to determine that a recession has occurred is often called the recognition lag. After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the president’s signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. The time to get a bill passed is often referred to as the legislative lag. Finally, once the bill is passed it takes some time for the funds to be dispersed to the appropriate agencies to implement the programs. The time to get the projects started is often called the implementation lag.

Thus, it can take many months or even more than a year to begin an expansionary fiscal policy after a recession has started—and even then, uncertainty will remain over exactly how much to expand or contract taxes and spending. When politicians attempt to use countercyclical fiscal policy to fight recession or inflation, they run the risk of responding to the macroeconomic situation of two or three years ago, in a way that may be exactly wrong for the economy at that time.

3. TEMPORARY AND PERMANENT FISCAL POLICY - A temporary tax cut or spending increase will explicitly last only for a year or two, and then revert back to its original level. A permanent tax cut or spending increase is expected to stay in place for the foreseeable future. Most people and firms will react more strongly to a permanent policy change than a temporary one. This fact creates an unavoidable difficulty for countercyclical fiscal policy. The appropriate policy may be to have an expansionary fiscal policy with large budget deficits during a recession, and then a contractionary fiscal policy with budget surpluses when the economy is growing well. But if both policies are explicitly temporary ones, they will have a less powerful effect than a permanent policy.

4. STRUCTURAL ECONOMIC CHANGE TAKES TIME - When an economy recovers from a recession, it does not usually revert back to its exact earlier shape. Instead, the internal structure of the economy evolves and changes and this process can take time. Fiscal policy can increase overall demand, but the process of structural economic change—the expansion of a new set of industries and the movement of workers to those industries—inevitably takes time.

5. POLITICAL REALTIES AND DISCRETIONARY FISCAL POLICY - A final problem for discretionary fiscal policy arises out of the difficulties of explaining to politicians how countercyclical fiscal policy that runs against the tide of the business cycle should work. Politicians often have a gut-level belief that when the economy and tax revenues slow down, it is time to hunker down, pinch pennies, and trim expenses. Countercyclical policy, however, says that when the economy has slowed down, it is time for the government to go on a spree, raising spending, and cutting taxes. This offsets the drop in the economy in the other sectors. Conversely, when economic times are good and tax revenues are rolling in, politicians often feel that it is time for tax cuts and new spending. But countercyclical policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending.

KEY DIFFERENCES BETWEEN AUTOMATIC STABILIZERS AND DISCRETIONARY MEASURES

1) Timing of implementation - Automatic stabilizers are intended to be a first line of defense, since they almost immediately respond to changes in income and unemployment, to turn mild negative economic trends around. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag. Before action can be taken, the government must first determine that there is an issue and that action needs to be taken. Then it needs to design and implement a policy response. Then the law needs to be passed and the relevant agencies need to adjust and alter any necessary procedures so they can carry out the law. It is due to these significant lags that economists like Milton Friedman believed that discretionary fiscal policy could be destabilizing.

2) Scope of measures - On the other hand, automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy. Discretionary policies can address failings of the economy that are not strictly tied to aggregate demand. For example, if an economy is going through a recession because its workers lack a certain set of skills, automatic stabilizers cannot address that problem. Government programs, such as retraining, can address this problem.

3) Finally, automatic stabilizers, such as the tax code and social service agencies, exist prior to an economic fluctuation. Discretionary policies are made in response to a fluctuation and only come into existence once a fluctuation starts to occur.

4) Policy Flexibility - Of course, it is not possible to create an automatic stabilizer for every potential economic issue, so discretionary policy allows policymakers flexibility.