Understanding the Role of Governments in Regulating Economies
In 1681, when a group of French businessmen led by M. Le Gendre met the French Controller-General of Finances Jean-Baptiste Colbert, the minister asked the businessmen how the French state could be of assistance to the merchants. Le Gendre simply replied: “Laissez-nous faire” (leave it to us). This conversation, in a nutshell, captures the essence of a laissez-faire economic system which espouses a system where private transactions are free from government interference. The polar opposite of a laissez–faire economic system is socialism which is based on social ownership of means of production and workers’ self-management. Both of these extremes are theoretical at best. In reality, many economies in the world are a mixture of these diametrically opposite ways of running an economy.
If the 2008 financial crisis is any indicator, free market forces, if left to their own devices would slowly lead the market down a path of greed and extreme inequality. The government had to step in to save the systemically important institutions. In other words, these giant institutions not only represented the machinery that kept the economy going but also the savings of millions of households. The common man, in this case, would not have preferred the employment of his money to prop up the financial system. However, he also realized the role of the government in preventing absolute chaos. Optically, the government was a knight in shining armor.
Of course, humans are not particularly known for their satisfaction either. They always want more and more. If they consider all humans to be equal, they want to be first among equals. Therefore, an absolute socialist system clashes with a basic human need of acquiring more wealth and material possessions. An economic system which provides for human needs but chokes human wants will soon face a revolt. The world, therefore, prefers a happy medium—a balance between laissez-faire capitalism and socialism.
Recently, Margrethe Vestager, the European Commissioner for competition locked horns with global behemoths Google and Facebook in Europe to prevent these near absolute monopolies from using anti-competitive practices. Many people view this government regulatory intervention as a force for good whereas others view such actions as restrictive. However, most issues become clear if we keep the common man or the lowest common denominator at the center of the debate. The question then becomes: how does a government create an economic policy that is fair for all and gives the common man a level playing field?
Any economic policy must serve most of the population, particularly the weak and the disenfranchised. In a democracy, it is very natural the voting population wants the government to work for them and meet their needs. In addition to their support, they pay taxes to make sure basic public goods such as highways and bridges are provided for.
More importantly, modern governments have a variety of ways in which they influence economic systems, e.g., trade policy, monetary policy, fiscal policy, and other ways to keep the markets functioning and the common man from harms’ way should the markets turn greedy. As mentioned above, there are many policy instruments at a governments disposal in a democratic system. There are two which are of prime importance, i.e., fiscal policy and monetary policy.
In simple terms, fiscal policy is the relationship between a country’s wallet and the wallets of its citizens. The word fiscal is derived from the word ‘fisc’ which means the royal treasury. The government typically regulates the flow of money in a governments’ coffers using taxation, borrowing or sale of its assets. When a government levies a tax, it basically takes the money away from the wallets of its citizens and puts in the government treasury. There are three types of fiscal policy, i.e., neutral, expansionary and contractionary fiscal policy.
When an economy is cruising along, a government adopts a neutral policy where the deficit spending (government spending in excess of the tax revenue collected is almost constant over a period of time. A government adopts an expansionary fiscal policy when the economy is sluggish or in a recession. In this case, government spending is in excess of taxes collected. If the government lowers taxes, in addition to increasing spending, that practice is known as “pump priming.” The idea is to put money in the wallets of consumers so that they spend it. Their expenditure becomes the revenue of companies who hire more people consequently reducing unemployment. Finally, a contractionary fiscal policy means that government spending is lower than usual. Again, this is a very simplistic explanation of fiscal policy but captures its essence. Fiscal policies are typically based on the theories of British economist John Maynard Keynes, who believed that governments can regulate economies by changing tax levels and public spending.
Although monetary policy is considered a sister policy to fiscal policy, monetary economics is a direct criticism of the Keynesian school of thought. Milton Friedman and the monetarists believe that control of money in an economy is important while allowing the rest of the markets to auto-correct. On the other hand, Keynesians believe that markets could follow a downward spiral unless the government intervenes through taxation and public spending. In the aftermath of the 2008 financial crisis, monetary policy has become the policy instrument of choice across the world. As central banks across the world such as the Bank of Japan, the European Central Bank (ECB) and the U.S. Federal Reserve attempt to revive their respective economies, monetary policy has become the policy of last resort.
Monetary policy uses the cost of short-term borrowing, i.e., the interest rate to regulate the supply of money in an economy. Its objective is to target the inflation rate or interest rate and maintain stability by keeping both rates at a normal level. The origins of formal monetary policy an important instrument of a governments’ economic policy dates back to 1694, when the Bank of England started printing currency notes backed by gold.
At the highest level, during a recession, the central bank of a country increases the money supply by doing a couple of things. First, it can reduce the interest it charges other banks for lending money. This, in turn, incentivizes those banks to make different types of loans (mortgages, auto loans, etc.) at lower interest rates to the consumers. Second, it can buy debt instruments of other banks and provide them money in return thereby increasing liquidity. This liquidity manifests as more loans made by banks to the common consumers. The idea is that the consumers, flush with liquidity, will start spending their money and drive up inflation. This will also help reduce unemployment. In an expansionary economy, the goal is to reduce inflation. Therefore, the central bank will adopt the reverse of the actions outlined above.
There are three things to remember when it comes to sound economic policy. First, if we were playing a game with three players, i.e., the government, the common man and the corporates, monetary and fiscal policy are the strategies government can adopt to influence the other players’ moves. The only difference is that it is not a zero-sum game. The pie (the overall economy) must keep getting larger.
Second, the pie must be distributed fairly. Finally, good policies rely on good measurement. Mark Twain, once said, “Facts are stubborn things but statistics are pliable.” For most politicians, this means refraining from massaging numbers for short-term gain.