Starting roughly with FDR, influenced by John Maynard Keynes, fiscal policy was seen as the best way for the central government to help the economy. That would change, in part because of ideas advanced by economist Milton Friedman. Phillip VanFossen writes:
The use of monetary policy to stabilize the economy was put to the test in the late 1970s. Early in that decade, the economy received a shock when the Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo on the United States and other oil-importing countries. Supplies of oil dwindled, driving up the price of gas. The inflation rate, which had already reached worrying levels, soared into double digits. As the economy struggled with rising prices, business activity slowed, and the unemployment rate climbed. The result was an unhappy economic situation known as stagflation.
Such situations often tempt leaders to violate the simple principle of free markets. Rather than reducing regulation and allowing the economy to organically work its way back toward equilibrium levels, governments often hope to intervene and nudge the economy quickly back to health. But by violating the free action of the market, things are made worse by these well-intentioned regulations.
President Nixon tried to curb inflation by imposing temporary controls on wages and prices. As soon as the controls were lifted, however, prices shot up again. In 1974, President Gerald Ford launched an anti-inflation crusade called Whip Inflation Now, or WIN, but inflation remained a problem. While running for president in 1976, Jimmy Carter scolded Ford for letting the "misery index" rise to more than 13 percent. The misery index is the sum of the inflation and unemployment rates. But after taking office, Carter watched helplessly as the index climbed to more than 20 percent.
Nixon's wage and price controls failed to make things better, and succeeded at making things worse. Ford, although criticized by Carter, actually succeeded in nudging the "misery index" lower by the end of his brief time in office. Carter's actions, in retrospect, seem confused and erratic. Carter encouraged Americans to use less energy and simply adopt "lower expectations" - the voters were unimpressed, and refused to give Carter a second term in office.
In contrast to Carter's attempt to simply persuade the American public to get used to a lower standard of living, get used to using less energy, and get used to having less wealth, Ronald Reagan was chosen by the voters in the 1980's. Seeking economic solutions, Reagan worked with
Paul Volcker as chair of the Federal Reserve Board to bring inflation under control. Influenced by Friedman's writings on monetary policy, Volcker set out to slow the growth of the money supply. The result of his slow-growth policy was a far faster reduction in the inflation rate than most economists thought possible. Inflation dropped from 13.6 percent in 1980 to 3.2 percent in 1983.
Reagan orchestrated a shift from fiscal policy to monetary policy. The result was an era of prosperity for the nation. Volcker's work used a short-term contraction in the money supply - or at least in the growth of the money supply - to lead to long-term growth in the economy. The 1980's were an era of rising incomes for all Americans and a rising standard of living for all demographic groups. By creating wealth, the Reagan economy created more employment at higher wages.
Politicians, more than economists, fall prey to fallacy of the "zero-sum game" view of wealth. In calculating and projecting the possible impacts of various policy options, one must remember that the total amount of wealth can, and should, increase. The objective of policy should be to create an environment - by reducing regulations - which allows for maximum wealth creation. An economy can grow the most wealth by getting the government out of the way - and maximizing the market's freedom.
To be sure, neither fiscal policy or monetary policy is a panacea; neither is the perfect solution to cure all economic woes. Reagan's prosperity, while enriching Americans at all income levels, took longer to come into effect. At first, under Volcker's contraction of the money supply, interest rates rose, business activity stalled, and unemployment actually increased. After this transitional effect, however, inflation fell, unemployment fell, and business activity created rising wages.
Policy makers and economists continue to ponder the mix of fiscal policy and monetary policy. The ideal mix is to reduce government intervention in both areas and let the economy find its own organic equilibrium. But political realities often trump economic common sense.
