Macroeconomic policies - the global context

Whether developing, emerging or developed, economies operate in a global context, and share similar concerns and objectives regarding trade, exchange rates, stability and equality. Here we consider some policy options to achieve objectives and manage problems.

Measures to reduce deficits and debt

There are several policies available to reduce fiscal deficits, including:

Reducing government spending - 'belt tightening'

A possible policy is to reduce 'current' public spending rather than capital spending.

The benefit of this is that current spending on wages and operating costs will not compromise future growth and productivity in the relevant government department.

However, there will be conflicts with this strategy, in terms of possible job losses, and increases in poverty and rising inequality – depending on where the cuts are made and how deep they are.

Also, it may take time to reduce public sector spending, or bring it under control.

Increasing the productivity of the public sector

If cutbacks are unpopular, difficult and sometimes counter-productive then improving the productivity of factor inputs used in the public sector is a possible medium term strategy. Getting ‘more’ out of the scarce resources being used could be achieved by changing working and management practices and upgrading the technology used in the public sector.

Increasing tax revenue

The second major strategy is to reduce deficits is to raise tax revenue.

This could mean either raising tax rates as a percentage, or altering tax free allowances.

However, there are risks with raising taxes. According to the Laffer curve, increasing tax rates may actually reduce revenue through a disincentive effect.

A tax increase can reduce revenue

Measures to reduce poverty and inequality

There are several policies that can be used to reduce poverty including increasing the benefits available to those in poverty.

  1. Reducing unemployment is also a way to reduce poverty, as unemployment is a major cause of poverty.
  2. Increasing spending on welfare benefits.
  3. Increasing the degree of progressiveness.
  4. Raising the minimum wage.
  5. Subsidising the building of houses, and subsidies towards rent payments.
  6. Controlling the prices of important resources, such as rent controls of caps on food prices.

The role of monetary policy in stabilising economies

Monetary policy involves changing either the price of money – its interest rate – or the quantity of money, in order to control inflation and stabilise the value of money. Keeping the value of money stable has long been an objective of governments, and later of independent central banks.

Monetary policy is a counter-cyclical policy in that it works to moderate changes in aggregate demand - with policy being loosened when aggregate demand is growing slowly or not at all, and tightened when aggregate demand is growing too quickly for the current capacity of the economy.

Short and long run

The use of monetary policy is regarded as a short term policy in that it is generally accepted that 'money is neutral' in its long term impact. It we take a long range view of an economy through time, the value of money and the quantity of money may change without having an impact on economic growth, or employment levels. Growth and employment levels in the long term are determined more by the availability, quality, and efficiency of factors of production, and factor productivity, than by the price or availability of money.

However, in the short run it is accepted that changes in monetary conditions - interest rates and the quantity of money - can have a direct and significant effect on economic growth and jobs. Hence, governments and monetary authorities do not have long range targets for the value of money - only that the supply of money and its growth should be controlled and pegged closely to the economy's ability to grow in the medium term - namely, close to the economy's trend rate of growth.

While most central banks do not have specific long term targets - other than to achieve monetary stability - they will set short term 'tactical' targets, for example, the Bank of England's daily operations are designed to achieve a specific interest rate or exchange rate1.

How does monetary policy work?

In 'normal' economic circumstances, monetary authorities use monetary policy to influence the demand for money, which then influences aggregate demand and the real economy and the rate of inflation.

Open market operations

The conventional method by which this is accomplished is by central banks manipulating the rate of interest through a process called open market operations (OMO) While this operates differently in different countries (or monetary areas such as the Eurozone) the basics of OMO are similar.

If a central bank wishes interest rates to fall to stimulate economy activity, it will enter the money market and purchase existing government securities (Treasury bonds or bills) from the banking sector. This transaction injects money into the financial sector which means that, as with all assets, an increase in supply drives down price - hence, in this case interest rates fall.

To engineer an increase in rates, the central bank will sell securities to the banking sector, which soaks up money and creates a shortage, which drives up its price - its interest rate. Most central banks will have a regular time at which they undertake OMO, and it is usually on at least a weekly basis.

Changes in rates then work their way to other 'market' rates, such as the rate at which banks lend to each other, and eventually on to rates which affect households and individuals, including mortgage rates, and credit card rates. This reinforces the idea that monetary policy is short term given that the 'time horizon' is measured in hours and days.

However, interest rates can fall to such a low level that less conventional methods are required.

The monetary transmission mechanism

The ‘monetary transmission mechanism’ shows how interest rates work their way through the economy, affecting asset prices, confidence, exchange rates, and finally on to the price level. The transmission mechanism highlights the 'interest rate channel' through which monetary policy operates on the rest of the economy.

Monetary transmission mechanism

Expansionary monetary policy will shift the aggregate demand curve to the right, and contractionary policy will shift it to the left.

Monetary policy

Quantitative easing - QE

As a result of very low interest rates central banks have looked to pump money directly into the economy when growth has slowed or when economies enter a recession. QE involves the purchase of government bonds which lowers the interest rates (or yield) on these bonds.

The effect is to push interest rates down on other loans, such a mortgages. This makes it cheaper to borrow money, which encourages spending.

QE also works by stimulating asset prices - holders of bonds may now wish to invest in these other assets, which pushes up their prices. Asset holders across the economy may now feel more confident to spend money, which increases aggregate demand.

Measures to increase competitiveness

The significance of competitiveness

Improvements in competitiveness are likely to lead to a range of benefits to an economy, including the following macroeconomic benefits:

  1. Increased exports which increase aggregate demand leading to job creation and greater economic growth.
  2. Improvements in a country's balance of payments.
  3. Downward pressure on prices as goods and services are produced more efficiently.
  4. From a microeconomic perspective, firms can gain in terms of:

  5. Increased export revenue.
  6. Increased market share of domestic firms.
  7. Increased profits.

Policies to improve competitiveness

Policies need to address the underlying causes of poor competitiveness, including domestic inflation, and poor labour productivity.

In terms of controlling inflation, tight control of the money supply (monetary policy) along with prudent government spending (fiscal policy) will provide a low inflation environments.

However, perhaps the most appropriate long term solution to competitiveness issues it to implement various supply-side initiatives, including:

  1. Investment in education and training to upgrade knowledge and skills, especially in terms of relevant IT skills.
  2. Encourage inward migration to close any skills gap.
  3. Adopt measures which will improve the flexibility of labour and the occupational mobility of labour.
  4. Tax incentives to encourage firms to reinvest profits into new technology or other capital expenditure.
  5. Improvements in infrastructure which enables goods to be produced and distributed at lower cost.
  6. Privatisation of state-controlled enterprises to enable them to compete in free markets.
  7. Deregulation of previously regulated industries to enable new firms to enter the market.

Analysis of policies

In terms of demand-side policy, including tighter monetary and fiscal policy, there are likely to be conflicts between achieving increased competitiveness and other objectives.

For example, policies to prevent inflation can dampened down growth, and cause job losses.

Higher interest rates can also deter capital investment, which itself would worsen competitiveness in the long run.

On the supply-side, most of the individual policies identified are expensive to design and implement, and are likely to take a long time to have any effect. For example, investment in education may take a decade to have an effect.

More specifically, while improving infrastructure is expensive and provides benefits in the long term, the short term effect may be increased disruption and considerable pollution.

Privatisation may result in falling wages for employees and a loss of job security, and may simply convert state owned natural monopolies to privately owned ones, with no efficiency gains.

Finally, encouraging inward migration may create issues regarding the pressure of increased demand for housing, education and healthcare.

Controlling global companies

Transnational companies (TNCs) are those multinational companies that do not have a single headquarters in any one country – in other words they are ‘footloose’. This means that they are not easy to control and regulate.

TNCs are often monopsonies and can pay below the market wage rate, and employ fewer workers than competitive firms.

In some cases, in order to encourage FDI from TNCs national governments may waive or reduce environmental regulations and standards, or even control or reduce the minimum wage.

Transfer pricing

TNCs can use tax efficient schemes to push resources around their network of companies and subsidiaries to take advantage of low tax rates. This is called transfer pricing and arises because of different global tax rates.

Goods tend to be produced in those countries with the lowest production costs, and sold to those where high revenues can be earned. In terms of profits, these can be declared in those countries with the lowest tax rates or where tax incentives are at their highest.

In terms of taxes paid by TNCs, national tax authorities may negotiate large discounts as ‘sweeteners’ to prevent them from moving elsewhere.

Perhaps the most obvious difficulty facing national governments is the concern that TNCs will simply restructure their tax affairs to avoid any attempt to regulate them or impose special taxes on them. The OECD (Organisation for Economic Co-operation and Development) has attempted to get its 38 members to apply a common approach to dealing with transfer pricing.

OECD and tackling tax evasion

General problems for policy-makers

Lack of information

Effective intervention in an economy requires accurate and comprehensive knowledge of macro-level data, including current levels of inflation, unemployment, trade flows, growth rates, and so on. Official data on such variables cannot be expected to provide a ‘complete’ picture.

Indeed, much activity may be hidden from measurement as it takes place in the ‘hidden economy’. The hidden economy is composed of three elements:

  1. The ‘shadow’ economy, which includes firms and individuals who are pursuing legal production or work activities, but who may hide some or all of their income;
  2. The ‘underground’ economy, which involves illegal activities, such as burglary, and;
  3. The ‘informal’ economy, which includes small scale enterprise which remain unregistered.

There are, of course, ways to estimate the size of the shadow economy, which include:

  1. Surveys of companies and households.
  2. Assessing discrepancies between official data on difference aspects of an economy.
  3. Changes in monetary variables not tallying with measurements in the real economy.
  4. Changes in the demand for currencies.
  5. Electricity consumption as an indicator of economic activity.

Several influential economists, including Milton Friedman, have argued that governments can never know enough about an economy to adopt active and interventionist policies, and as a consequence advocated highly conservative approaches to policy.

For example, control of the money supply to achieve a desirable inflation rate would be more preferable to active monetary policy (by increasing the money supply) because its effects are uncertain. While knowledge is likely to improve over time it is inevitable that government intervention will be subject to some information failure.

Time lags

Similarly, information flowing to policy makers may be out of date as soon as it is published. Even the most ‘up-to-date’ information will be painting a picture of what was happening several months, or possible years ago. This means that the timing of policy interventions may not be optimal - with some policy decisions taken too late and some possibly too early.

Steering an economy has been likened to steering a huge ship - decisions to turn one way or another, or to slow down or speed up must be made well in advance of the point or destination where the ship is headed. To continue the analogy, an economy has a huge ‘turning circle’!

Unintended consequences

Decisions taken by policy-makers may result in outcomes in the real economy that were not anticipated.

There are numerous examples of possible unintended consequences, ranging from increases in tax rates designed to raise revenue that might actually cause revenue to fall because of increased tax evasion; and welfare payments that can trap people in poverty.

Moral hazard

Moral hazard may also increase as a result of intervention. Moral hazard occurs when individuals or firms act recklessly because they believe that they are protected from the adverse effect of their behaviour. The term comes from the insurance industry, when it was noted that providing insurance against the negative impact of a hazard could lead the insured to deliberately seek out the hazard, and collect an insurance pay-out.

For example, an accepted consequence of financial support to the banking sector in the early stages of the financial crash in 2008-9 was that some US banks thought they were ‘too big to fail’ and would be bailed out, and hence continued to make risky loans to the sub-prime housing market.

Moral hazard has been widely studied in economics, and has the potential to occur as a result of many types of intervention. This includes individuals continuing to smoke cigarettes because healthcare services will provide treatments for lung conditions, and people choosing not to work because welfare benefits provide an insurance against a zero income.

Failings of overseas aid

Similarly, one unintended consequence of providing aid to developing countries is that they may fail to develop their own economies effectively, or that aid may not trickle down through the economy to reach the poorest, who then remain at a subsistence level. In this situation, savings cannot be generated and the economy continues to rely on international aid.

A given level of saving is required to provide a flow of funds to the financial sector, but the poorest will have a marginal rate of saving of zero or even a negative one. Hence most developing economies still have a ‘savings gap’ which aid may not help close, or make even worse.

Failures in farm support

Throughout the global economy governments have wanted to protect farmers from uncontrolled market forces. Supply-side shocks in the form of bad weather and disease have caused considerable instability in agricultural markets, through the so-called Cobweb effect, leading to dynamic price instability. This has led governments to introduce schemes to reduce instability.

However, intervention schemes can cause unintended consequences.

For example, establishing a guaranteed price system may led to over-production, where farmers are incentivised to increase output beyond the natural market equilibrium.

Guaranteed prices and market failure

While farmers increase output (via an expansion along the supply curve, a to b), consumers respond to higher prices by contracting demand (a to c), with the net result that there is a surplus of unconsumed output. In the case of many agricultural goods, storage is difficult, excessively costly, and not possible for perishable goods. The result may be that excess stocks are destroyed. Which, clearly, is not an outcome that anyone would have deliberately wished for.

Farmers (and other producers) may be supported with direct subsidies. As with guaranteed prices they will encourage farmers (and producers) to increase output. However, the subsidy may be greater than is required with the result that economic welfare is lost, rather than gained.

This means that the intervention reduced welfare below the level of that which existed as a result of the market failure.

Regulatory capture

The possibility that regulators slowly ‘switch sides’ by defending the interests of those firms or industries that are charged with regulating was first identified in the 1950s, and was studied extensively by Chicago economist George Stigler in the 1980s [1].

Regulatory capture has been the subject of much research detailing industries where such capture appears to exist.

While outright corruption may be at work in some instances, it is most likely that regulatory capture is a by-product of the need of regulators to understand the fine detail of how an industry works.

In attempting to understand exactly how an industry is composed, and how it operates, it is possible for regulators to understand the range of problems faced in the industry, and to be more sympathetic to practices which, ultimately, are against the interests of the public.

Examples of regulatory capture:

  • Quality and safety regulators giving notice of inspection visits,
  • Frequent staff interchange between regulator and industry,
  • The reluctance of either party to be strongly critical of the other, and:
  • Regulators engaging in increasingly 'closed' and not transparent consultation processes.

The existence of regulatory capture casts doubt on the rigor and effectiveness of regulation.

Dealing with external shocks

External shocks can arise in many forms, including financial shocks, natural shocks, including the effects of bad weather on commodity prices, and shocks associated by war and political conflict – such as the Gulf War, or conflict in Afghanistan.

Globalisation has increased the risks associated with global shocks, given that countries are closely linked. Feedback affects can amplify shocks between countries.

Shocks can be dealt with by domestic policies or by a co-ordinated approach between national governments, as with the financial crisis of 2008-09.

In recent months global gas prices have risen, and this has led many governments to continue the search for alternatives to gas, including renewable energy resources. It has also led national governments to set caps on the amount by which gas prices can increase.

Fuel poverty is of great concern in many developed and developing countries, and this has seen a push towards renewables, and to more efficient heating and insulation of buildings. Here, government has a role in terms of providing incentives to insulate buildings,

At the other extreme, global warming appears to have triggered numerous severe weather events, and governments will be expected to become more involved in protecting homes from flooding, and to protect coastlines from erosion.

The global pandemic has also highlighted the need for much closer co-operation between national governments and healthcare systems to deal with health shocks and their after effects.

[1] Stigler, George J. “The Theory of Economic Regulation.” The Bell Journal of Economics and Management Science, vol. 2, no. 1, 1971, pp. 3–21. JSTOR, www.jstor.org/stable/3003160. Accessed 15 Oct. 2020.