Chapter 12: The agencies of economic policy and

growth policy

Outline:

01st The long-term commitment of state expenditures

02nd The slow legislative machinery

03rd The problem of the budget balance

04th The federal structure of the state

05th About the problem of the independence of the central bank

06th About the economic policy problem of tariff autonomy

07th The significance of the Council of Economic Experts

08th Problems of international economic policy

01st The long-term commitment of state expenditures

We had previously dealt with the question of the extent to which employment policy measures were suitable for increasing employment and with the further question of to what extent it must be expected that these measures would have negative secondary effects on other economic policy aims. In this chapter, we will now address the question of which agency should be entrusted with employment policy tasks.

Here, too, we must assume that there is a variety of executive agencies which could possibly implement measures to influence employment positively, e.g. there are the executive and legislative authorities, there are the government authorities in the narrower sense and the central bank. Within the government authorities there are the federal government, the federal states and the municipalities, and as non-governmental authorities e.g. collective bargaining partners could be entrusted with certain political tasks such as the obligation to agree only on wage increases which do not endanger monetary stability.

The individual agencies differ in the way in which a decision is reached and in the rights an agency has in order to carry out the tasks entrusted to it. First, let us look at the activities of the government, where an employment policy effect can emanate especially from state expenses.

In the context of economic policy, generally expenditure policy has priority over fiscal policy. State expenditures, as we have seen in the previous chapters, have primarily a greater multiplier than taxes.

For government expenditures is valid:

dY = dG_St * 1 / ( s + t );

whereas for tax revenues is valid:

dY = (dT-1) * 1 / ( s + t )

· Y: domestic product

· G_St: government expenditures

· T: tax revenues

· s: savings propensity

· t: tax rate

A comparison of the effectiveness of both an increase in government expenditures as well as a reduction in tax revenues naturally presupposes that we compare an equal amount (e.g. 1 billion) of changes in government expenditures and tax revenues with each other, i.e. dG_ST and dT are to be set at the same size and this in turn means that the revenue multiplier is lower by the value of 1 than the expenditure multiplier.

With government expenditures arise furthermore both primary effects and induced secondary effects, with taxes arise only the induced secondary effects. Let us take as an example the case where the state hires more civil servants in period 0 and thus increases government expenditures. The actual primary employment effect in this case is that the state employed new labour force in the period 0.

Secondary (and indeed positive) employment effects arise here from the fact that the additionally employed civil servants spend their income on consumer goods in the respectively next period and that in this way more consumer goods are produced and therefore additional labour forces are employed also. This process continues in the following periods. Since only a certain part of the additional income is spent on consumer goods, the respectively induced employment increases are smaller in each period. Thus, this is an infinite series with a finite value.

Contrary to this, a reduction in tax revenues in period 0 causes initially no primary increases in employment at all. Only privately disposable income increases to the extent to which tax rates are reduced. However, the employment effects induced in further periods are identical to the secondary employment effects triggered by increases of government expenditures.

But government expenditures are for the most part committed on a long-term basis: This applies particularly to expenditures which are determined by international treaties, such as defence expenditures, as well as to the contributions to the European Union. Civil servants are furthermore not cancellable. After all, a reduction in the social budget for economic policy reasons may possibly contradict to social policy aims.

A special role falls to voter-effective expenditures: Politicians tend to spend predominantly on those expenditures that generate voter gains and to realise expenditure increases predominantly just before elections. In political economics, it is assumed that voters forget very quickly what advantages and disadvantages they gain from the state, so that it is advantageous for politicians to implement such measures immediately before the elections which trigger positive effects relatively quickly, while measures that initially burden the population and only show their positive effects much later are implemented shortly after the elections.

A special importance in this context is attached to infrastructure investments: although infrastructure investments have a greater growth effect in the long term, they are less perceived by voters since a positive impact on the income of the voters will only occur in the future.

02nd The slow legislative machinery

Variations in taxes are in general only possible due to legislative changes. Government expenditures, by contrast, are usually decided by ordinance.

The legislative process is very time-consuming: First, coalition negotiations are needed between the parties involved in the government, provided that the government consists of several parties. Sometimes it is necessary to reach agreements with the interest groups in order to prevent that the implementation of the laws will be blocked by these groups. Almost every law must be prepared initially at the administrative level.

After the legislative draft has been introduced into parliament by the government, it is discussed in several readings in parliament and partly referred to subcommittees. In federal states, the laws must also be discussed and passed in a second chamber (in the FRG in the Bundesrat i.e. Federal Council) provided that these laws affect the interests of the federal states. Sometimes the legislative drafts are remitted to the first chamber (in the FRG thus to the Bundestag i.e. Federal Parliament). Then a mediation committee is often required to reach a final agreement.

In the Stabilisation Act of 1967, an attempt was made to reduce these deficiencies, which are mainly due to a loss of time: According to this, short-term tax variations are possible by means of ordinances in order to enable that tax rate changes which are motivated by economic policy can be carried out more quickly. In this case, the adoption by Parliament will take place later. In this way it shall be ensured that the laws intervene in the economic process in due time and help to reduce unemployment.

Furthermore, there is a necessity for medium-term financial planning. In this way, it shall be achieved primarily that the state budget remains balanced in the longer term, i.e. within an economic cycle. This purpose is also served by the introduction of an economic equalisation reserve.

03rd The problem of the budget balance

Votes maximisation leads to an explosion in expenditures if expenditures can be financed in deficit. Increases in government expenditures lead to welfare gains for voters, while tax increases are equivalent to a reduction in privately disposable incomes. The politicians could thus increase their electoral chances if they were able to raise state expenditures more than the tax revenues that are needed to finance these expenditures. Exactly this, however, will become possible if the increases in government expenditures are financed in deficit, i.e. if they are covered by government debt or by loans from the central bank. Thus, in a democracy there is a trend towards deficit financing.

Now we must realise that even if government expenditures are financed in deficit, the voters will finally have to pay for these increases in government expenditures. The demand of the state as well as that of private households always refers to one and the same scarce resource stock. Production factors used in the production of public goods can no longer be used to produce private goods, so that regardless of how government expenditures are financed, the share of private goods decreases to the same extent as the share of public goods increases.

But this process is no longer readily apparent to if government expenditures are financed in deficit. The fact that fewer resources are now available for the production of private goods impacts in the form of price increases, which are, however, raised directly by enterprises, although it is of course the state with the increase in demand for public goods that ultimately triggered these price increases. However, since price increases are raised visibly by enterprises and not by the state, the correlation between increases in government expenditures and price increases for private goods remains largely hidden to voters.

By means of a demand for budget compensation, a limitation of expenditures can be achieved. Only such increases in expenditures will then be possible which are also accepted by the voters as they agree to the tax increases. But the question is whether this principle is still valid in the case of underemployment. According to Keynesian ideas, a deficit leads to an increase in the domestic product and thus does not lead to a reduction in real income. Nevertheless, also in this case, the share of individual goods in the domestic product decreases if the state increases its expenditures and finances this increase in expenditures in deficit. The right of the voter to decide for himself by means of the elections how the domestic product shall be divided among individual goods and collective goods can only be realised if the budget is balanced.

These limitations show that the principle of budget balance should never be related to a short period. If the state is obliged to balance its budget in every period, including the economic downturn, it can only fulfil this obligation in times of economic downturn by realising a compensation due to the decrease in its tax revenues by either raising tax rates or reducing government expenditures. This is referred to as procyclical fiscal policy. However, this contributes to a worsening of the recession and should therefore be avoided in any case.

It would be wrong to misunderstand the supporters of budget balance as though they were ever calling for a pro-cyclical policy. A pro-cyclical policy is rejected equally by both supporters and opponents of Keynesian employment policy. The difference between the two groups is that supporters of Keynesian policy demand that the state pursues anti-cyclical policy, i.e. that in times of recession it increases expenditures in the sense of a "go" or reduces tax revenues, and in times of economic booms it reduces expenditures in the sense of a "stop" or raises tax rates.

Such a stop and go policy, however, is rejected by the opponents of a Keynesian policy, since in this way particularly the uncertainty of long-term investment projects increases, and such a policy is therefore detrimental to long-term growth. Rather, it was necessary for the state to align its expenditures with long-term aims and ensure budget balance for the entire economic cycle.

04th The federal structure of the state

Expenditures and taxes are decided not only by the federal government and the federal parliament, but also by state parliaments and local councils. But this means that economy and employment are not only influenced by the fiscal policy activity of the federal government, but that the fiscal policy behaviour of the federal states and municipalities also influences the macroeconomic target figures. It is therefore also not sufficient if only the federal government aligns its fiscal policy with economic requirements. The federal states and municipalities must also consider the economic effects of their actions.

This demand applies in particular because the federal states exert influence on macroeconomic variables not only by their own financial policies, but rather also indirectly via the fact that they have to give their approval to many legislative projects in the Federal Council and can thus counteract the economic policy of the federal government.

Due to the different party orientation of the state governments, there is indeed a danger of an inconsistent economic policy at both federal and state level. Since the elections to the Federal Parliament and the state parliaments generally take place at different times, there is a great danger that the composition of the state parliaments will be different from that of the Federal Parliament and that therefore often the government in the federal states is formed by the parties which belong to the opposition in the Federation.

It is precisely this possibility of a different composition of the Federal Parliament and the Federal Council that entails the danger that the parties block each other and that therefore neither the Federal Government nor the state governments are able to fully realise their aims.

It is precisely because of these conflicts and inefficiencies that it should be ensured that the Federal Council can only prevent the submissions of the Federal Government and the Federal Parliament in cases where the well-understood interests of the federal states are really at stake. However, there is always the danger that the representatives of the states may pretend to represent the interests of the states, but that in practice the opposition to federal laws arises from different party affiliations.

In order to ensure that state parliaments and governments align their fiscal policy with the requirements of economic policy, it was decided in § 18 of the Stabilisation Act of 1967 to establish a Business Cycle Council in which the Federation and the states are represented. Furthermore, a limit on credit loans (§§19-25) is also provided for the states and municipalities. Finally, the states are required to align their activities expressis verbis with the macroeconomic aims. (§§ 1, 16)

05th About the problem of the independence of the central bank

The responsibility for economic policy lies with the state. However, the success of governmental fiscal policy depends among others also on monetary policy. For this reason, most central banks are legally obliged to support the economic policy aims of the state.

However, in all larger liberal democratic states there is a division of labour between the monetary policy of the central bank and the economic policy of government and parliament. The central bank is entrusted with the task of ensuring a sufficient supply of money, while governments and parliaments are responsible for determining government expenditures and tax rates.

Here, the central bank must, in accordance with the statutes of these financial institutions, ensure currency stability as the most important aim. This means, on the one hand, that the price level should be kept as constant as possible in the internal relationship, thus avoiding inflation. In the external relationship with other countries, by contrast, it is a matter of ensuring a considerable stability between the exchange rates of the individual currencies, since only if exchange rate fluctuations are not too large the risk of foreign trade will be reduced to such an extent that sufficient enterprises are willing to engage in international trade at all.

In this connection, we must consider the fact that, in addition to the general risks associated with most entrepreneurial decisions, there is an additional risk in foreign trade that, once the decision is made, currency relations will be changed, with the consequence that usually profitable businesses become loss-making businesses. It is clear that in such a case it cannot be expected that entrepreneurs will be sufficiently willing to incur these additional risks induced by foreign trade.

This division of labour between the central bank on the one side and the government or parliament on the other side is necessary to guarantee the basic aims of any democracy. Without strict adherence to this division of labour, there would be the danger that the state and the central bank as a whole would no longer fulfil the will of the people (the majority of the population).

Let us first consider a government and a parliament which - contrary to these aims of monetary stability - could significantly influence the money supply of the economy. If state politicians were in a position to decide for themselves on the money supply, there would be a danger that politicians would strive to finance as much state expenditures as possible by borrowing from the central bank to finance state expenditures and thus would determine the amount of money in circulation on their own. We have already seen above that in a representative democracy, politicians would be able to figure out their election chances in this way and that voters would no longer be able to decide for themselves to what extent an increase in the share of public goods (and at the same time a reduction in the share of individual goods) would increase their welfare.

But there are also further justifications for the independence of the central bank: measures to maintain monetary stability will increase welfare only in the long term. They are often associated with temporary welfare losses in the short term, which makes these measures extremely unpopular. If these decisions were to be taken by the government or parliaments, there would be a danger that politicians would refrain from such decisions, especially shortly before elections.

The independence of the central bank in Germany was also due to further, special reasons: the war generation lost its assets twice due to inflation, namely during inflation in the period after the First World War and during the currency reform at the beginning of the Federal Republic.

06th The economic policy problem of tariff autonomy

There is a danger that the standard wage policy of the trade unions will have an inflationary effect and cause unemployment. The responsibility for economic policy lies with the state, though. Because of that there emerged a demand for binding wage guidelines for the collective bargaining partners.

In the FRG, however, there is constitutionally protected collective bargaining autonomy. That is why the state has limited itself in the past (e.g. during the first grand coalition) to measures of 'moral persuasion'.

Thus K. Schiller introduced the Concerted Action in 1967. It provided for non-binding orientation data. It was acted on the basis of the principle of 'carrot and stick'.

The carrot consisted in the participation of the social partners in the Concerted Action, the stick consisted in the hidden threat to restrict collective bargaining autonomy in the event of failure. Participants of the Concerted Action were: the tariff partners and the state. The basis was § 3 of the Stability Act, which postulated the responsibility of the state for stability.

It can be shown that a success of a Concerted Action on the labour market can only be expected in the first rounds. Interest groups may be ready to cut back their own interests at short notice in times of need. In the long term, however, the Concerted Action is not able to prevent hereby the danger of inflation arising from collective bargaining autonomy.

The reasons for the long-term failure of a Concerted Action are found in the following facts:

Firstly, there is the contradiction between the aims of economic policy and structural policy. The determination of collectively agreed wage rates is primarily concerned with a structural problem, it is a question of which relations between wage rates shall be implemented in the individual branches of the economy.

But at the counselling in the Concerted Action the only issue is the overall economic wage level. In the attempt by individual trade unions to improve their position within the wage structure or even only defend it, disappears the willingness to renounce this aim merely for reasons of monetary stability and to be content with a wage in accordance with the wage guidelines. Thus a collective agreement is concluded at the meso-economic level of the sector, but wage guidelines apply to the economy as a whole.

Secondly, there are material disincentives, since an opt-out from the Concerted Action is materially rewarded. If an individual union forces a higher wage increase contrary to the wage guidelines of the Concerted Action, then the advantage of this union wage policy benefits only this one union, while the disadvantages, which consist in price increases, are borne by all employees, including those who have adhered to the wage guidelines. This means that those who adhere to the wage guidelines will be sanctioned and those who break them will be rewarded. With such disincentives it cannot be expected that the majority of the trade unions will adhere to the wage guidelines in the long run.

Thirdly, the official confirmation of wage increases leads to further wage demands. If the Concerted Action finds that a three-percent wage increase can be absorbed by the economy, and if therefore this three-percent wage increase is determined in the wage guidelines, it will no longer be possible for employers to start collective bargaining with an initial offer of less than 3%.

At the same time, most unions are pursuing the aim of demanding and asserting somewhat more in collective bargaining than has already been officially declared desirable by the government. Otherwise, there would be a danger that the members would turn away from the trade unions, as they have not achieved more than what had already been agreed within the framework of the Concerted Action. Thus, the unions will begin collective bargaining with wage demands that are considerably higher than the wage guideline.

An agreement between trade unions and employers presupposes that both sides are prepared to compromise and therefore make concessions. If, however, the employers have already started the negotiations with an offer that is actually at the upper limit, the negotiations will become particularly conflictual. At the end of the day, the result will usually be a wage that exceeds the wage guideline.

If the wage guideline is now based on labour productivity growth, then exceeding it would be undesirable from a macroeconomic perspective, though. The Concerted Action was intended precisely to prevent that inflation trends emanate from the labour market, but this is always the case when wage increases on average exceed labour productivity growth.

The attempt to circumvent this difficulty by requiring wage guidelines to be slightly below productivity growth generally fails because the public hardly accepts wage guidelines that are below the increase in labour productivity.

07th The significance of the Council of Economic Experts

The wage increases that can be absorbed macroeconomically are certainly interpretable in individual cases. This is because wage increases always influence a variety of economic policy aims. The trade unions are primarily concerned with income distribution. If wages are raised more than labour productivity increases, then either inflationary trends or unemployment are to be feared, depending on whether the central bank meets the increased need for money as wage income increases by expanding the money supply or not.

Economic growth can also be influenced by wage policy, as with wage increases the wage-interest ratio is changed as well, which itself is responsible again for the manner of technical progress. Depending on the severity of these side effects, a different wage guideline may be considered desirable. However, the assessment of these aims is based on interests.

Thus, there is a danger that the economic data will be interpreted in a manner that reflects the interests of industry and the state. Contradictory theories lead to different positions. The Federal Government represents interests, too.

It was precisely in order to avoid this conflict of interests that the Council of Economic Experts was founded, which shall determine the data relevant to the economic situation on a scientific basis in a way that is independent of interests. The tasks of the Council of Economic Experts consist:

· in the assessment how far the macroeconomic aims have been achieved;

· in pointing out erroneous trends and

· in recommendations to address these developments.

08th Problems of international economic policy

A necessity for the coordination of the individual political executing agencies results also from the international interrelations of the states: An import of unemployment and inflation via CB-imbalances is possible if a system of fixed exchange rates is present. If the price-increase rate abroad is higher than that of the domestic economy, there occurs a current account surplus:

Within the framework of Keynesian theory, the current account surplus leads to an increase in national income (Y) and at full employment to price increases:

By contrast, in the framework of classical theory, at a current account surplus an increase in the domestic money supply (M) is to be expected, which will have a price-increasing effect:

· P:Ausl/Inl: price level abroad/domestically

· Y: domestic product

· P: price level of goods

· M: amount of money in circulation

There is also an interdependence on the degree of integration of the individual national economies: the more interrelated the national economies are, the more is inflation or unemployment abroad transferred to the domestic economy.

Thus, the following effects result from an expansionary monetary policy abroad: The interest rate reduction abroad (i_Ausl) leads to an interest rate reduction in the interior (i_Inl) and thus to an economic revival in the domestic economy:

· i_Ausl/Inl: interest abroad/domestic

· Y: domestic product

An expansive fiscal policy abroad, by contrast, has the following effects: If the money supply remains constant, the deficit of the foreign state budget (A-T)_Ausl causes an increase in interest rates abroad (i_Ausl), which also leads to increases in interest rates domestically (i_Inl), thus reducing demand and along with it the domestic product:

· A-T: deficit of the state budget

The foreign trade relations within Europe were set by different monetary systems in the period after the Second World War: Initially, monetary policy cooperation took place within the IMS system by mutually supporting exchange rates, with the US dollar being the leading currency. Later, in the 1970s, the EMS system was created, which adhered to the aim of stabilising exchange rates but, unlike the IMF system, referred the leading currency to an artificially created monetary unit. Finally, in 1999, the European monetary order was formed with a single currency, the Euro. The problems associated with this, however, will not be addressed until the lecture on foreign economic policy.